The Bank of England is celebrating an anniversary — it is ten years since they began to determine monetary policy by setting interest rates. For a bank that was founded in 1694, it may seem that it was late joining the party of interest rate setting central banks. The Bank's roles and functions have evolved and changed over its long history but certain functions have remained. Since its foundation, it has been the government's banker and since the late 18th century, it has been banker to the banking system itself. The Bank also manages foreign exchange and gold reserves and the government's stock register. But to the general public, it now is most visible through its banknotes and interest rate decisions.

Its legacy stretches over 300 years of events that have influenced the workings of central banks everywhere. The Bank’s development has been inextricably intertwined with the development and growth of financial markets in the United Kingdom and elsewhere. The Bank facilitated the government’s use of the financial markets for its own financing needs, though not on today’s scale. The Bank was nationalized after World War II on March 1, 1946 and only gained operational independence from the Treasury in 1997 after the Labour Party won power.

After Labour’s victory in the 1997 election, the new government announced that it would transfer full operational responsibility for monetary policy to the Bank of England. However, other Bank functions were transferred elsewhere — debt management on behalf of the government was transferred to the Treasury, and the Bank's regulatory functions were passed onto the new Financial Services Authority. The 1998 Bank of England Act made the Bank independent to set interest rates. The Bank is accountable to Parliament and the wider public. The legislation provides that if, in extreme circumstances and the national interest demands it, the government has the power to give the Bank instructions on interest rates for a limited period of time.

Inflation targeting imperative

To perform its role as sole interest rate setter, the Bank established the Monetary Policy Committee which consists of five internal members and four external members. They were given the responsibility for establishing a coherent monetary policy with the use of an inflation target which is announced in the Chancellor of the Exchequer’s November Pre-Budget speech each year. In 2003, as part of a review to measure the UK’s readiness to join the European Monetary Union, the government took the opportunity to change its inflation target and the measure used to measure price changes. It lowered its target to 2 percent from 2.5 percent and changed its inflation measure to what is now called the consumer price index or CPI from the retail price index excluding mortgage interest payments or RPIX. The CPI uses the methodology developed by Eurostat for inter-country comparisons (harmonized index of consumer prices). While there are many computational differences between the two, it is what is omitted from the CPI that is most important. It excludes owner occupied housing — an important cost to UK residents.

The graph below shows interest rates for the past ten years as well as its inflation target and price measures. It should be added that there is a range of plus and minus 1 percent around the target. The Bank governor is required to send a letter to the Chancellor explaining what will be done to correct the situation should inflation breech the range, as he did in March for the first time. The second graph below shows the difference in inflation using the CPI and RPIX.

The communications conundrum

Central banks everywhere are being pressed to communicate their intentions more clearly and the Bank of England is no exception. To this end, Bank Governor Mervyn King, in both an interview with the Financial Times and in a speech to business economists, has pledged to give financial markets clearer guidance on how the Bank of England is likely to respond to economic data. Market economists’ opinions vary widely on how effective the Bank’s communications are. For example, some think that the Bank should release pre-prepared information for the quarterly Inflation Report sooner while others want clearer communication immediately after the monthly Monetary Policy Committee meeting. Now there is no statement unless policy is changed. Minutes are released two weeks after the meeting, a week sooner than the Federal Reserve and several weeks before the Bank of Japan. For example, the minutes for the March 19 and 20 BoJ meeting were only released on May 7. (There are no minutes for European Central Bank meetings.)

And the minutes themselves are under analysts’ scrutiny. Analysts complain that they have to sift through a mass of different opinions with no sense of the relative importance of many economic factors that are discussed. However knowing the relative importance would allow analysts to simulate the MPC’s interpretation of the changing economic environment. However, other analysts fret about the dangers of getting too specific. The purpose would not be to conceal information; but in the Bank’s effort to simplify and amplify its message the result could be misinterpreted. King thought the Bank had improved its communications and that its job was more difficult than that of other central banks because of the tension between the individual accountability of the individual members and the communication of an overall committee stance. One unique characteristic of the MPC is that the nine members are held individually accountable for their votes through a one person, one vote system.

Bank’s performance so far

In a speech to the Society of Business Economists, King said that Britain had transformed its economy from being one of the worst of the Group of Seven industrialized countries from 1950 to 1996 to arguably the best, thanks in part to structural policy changes. One of the Bank's biggest achievements over the past 10 years, according to Mr King, is an early understanding of the scale and significance of migrant labor from east Europe after the 2004 enlargement of the European Union. But this is an article for another day.

The challenge in setting interest rates lies in continually questioning conventional economic thinking and resisting the allure of relying on macroeconomic models and past statistical correlations. He acknowledges that the MPC's continual process of sifting through information can make it hard for others to understand how it interprets the data and what it thinks about economic risks. That is why King is now considering changing the way the Bank writes its minutes as well as the quarterly inflation report so that they provide more insight into the Bank's likely interpretation of events when future risks become present certainties.

King rejects the idea of publishing a forecast for interest rates. He told the FT that the Bank would not “do monetary policy by code word,” the practice by which the Federal Reserve and the European Central Bank use particular phrases to signal future rates decisions. He said, however, that he would work to give City economists a guide on how to interpret economic data when they are released so they will know how the committee is likely to interpret the data. As for emulating the ECB by holding a press conference immediately after their meeting, the Bank is opposed for a simple reason. While the ECB makes decisions by consensus with no formal vote taken, MPC members are individually accountable for their votes, making it inappropriate for King to represent them.

Bottom Line

Ten years ago, Chancellor Gordon Brown granted the Bank of England operational independence to set interest rates. The move has been a resounding success. However, the roots of its success go back before 1997 to as early as 1970 when successive governments liberalized the economy. The UK's inflation problem was finally defeated in the early 1990s enabling it to join other countries with low inflation and stable growth. Since 1997, the Bank has exhibited skill in implementing the monetary framework that is a testimony to the traditions in the venerable institution and its leaders.