Christopher Allsopp

United Kingdom Inflation Targeting and the Exchange Rate

The UKs monetary policy strategy is one of floating exchange rates and inflation forecast targeting, with the targeted measure referring to consumer prices. We consider whether it is welfare-reducing to target inflation in the CPI rather than in a narrower index and the role of the exchange rate in the transmission of monetary policy actions to CPI inflation. It is appropriate to model imports as intermediate goods rather than goods consumed directly by households. This leads to a simpler transmission mechanism of monetary policy while also offering a sustainable explanation of the weakness of the exchange rate/inflation relationship and making consumer price inflation an appropriate monetary policy target.

U.K. Inflation Targeting and the Exchange Rate

The United Kingdom*s monetary policy strategy is one of floating exchange rates and inflation forecast targeting, with the targeted measure referring to consumer prices. We consider whether it is welfare-reducing to target inflation in the CPI rather than in a narrower index; and the role of the exchange rate in the transmission of monetary policy actions to CPI inflation. We argue that it is appropriate to model imports as intermediate goods rather than as goods consumed directly by households. This leads to a simpler transmission mechanism of monetary policy, while also offering a sustainable explanation fore the weakness of the exchange rate/inflation relationship and making consumer price inflation an appropriate monetary policy target.

The Rise and Fall of the Dollar: A Comment

If readers of this paper were to ask themselves what the rates for the worlds major currencies are likely to be in, say, three years time, it is doubtful whether they would have much confidence in their predictions. Even conditional forecasts on the basis of particular assumptions about policy would be hard to make. This state of ignorance and our admission of it owes much to the recent behaviour of the dollar which, as Koromzay, Llewellyn and Potter so usefully discuss, largely defies explanation in terms of conventional economic analysis even when full use is made of the luxury of hindsight. That ignorance itself may, however, have important policy implications. These comments relate to both the theoretical and policy aspects of the paper, though the focus, as in the paper itself, is on the implications for policy. A general difficulty may be stated at the outset: the paper reasonably enough concentrates on the dollar in the I98os, but though this is much the most dramatic illustration of the difficulties in explaining exchange rate movements, it is not the only one. Thus ideally an explanation of dollar strength should be consistent with explanations given for previous dollar weakness (see for example, Bliss, I986), and for other recent major movements of exchange rates such as the apparently similar gravity-defying rise in sterling in the late I970S and early 198os. Where theory and empirical analysis fail, explanations tend to become ad hoc with a danger that false or over-strong policy conclusions are drawn. Even a casual comparison with the United Kingdom raises some questions as well as supporting the general thrust of this paper. Thus the monetary fiscal mix in the United Kingdom was very different from that in the United States (according to OECD figures the structural budget moved to surplus by some 6% of GDP between I979 and I982) which must at least suggest a cautious approach to some of the simpler stories that trace the rise in the dollar to United States fiscal irresponsibility. (The United States experience which, as the paper demonstrates, does not accord with conventional models of the overshootingtype also throws doubt in the other direction about applications of that kind of model to the United Kingdom, for example, by Buiter and Miller, I98I.) Of course, the United Kingdoms situation was special because of North Sea oil. But if North Sea oil was important, the obvious reason would be due to its effect on relative current account positions, which does not seem to work well for the United States and, in any case, most estimates suggest that oil should account for only a part of the rise in sterling (see Powell and Horton, I985, for a survey). And, as in the United States, empirical models were notably unsuccessful in predicting the exchange rate (Haache and Townend, I98I).

The Pivotal Role of the ECB in the New Europe

With the successful launch of EMU at the beginning of January 1999, the key question is how well the new grouping of 11 countries – Euroland – will perform macroeconomically. Strains and difficulties between countries appear solvable if the context is a healthy growing Europe, but are more dangerous if the group as a whole performs badly. In this article Christopher Allsopp and David Vines argue that the European Central Bank has a pivotal role. This is not just for the obvious reason, enshrined in the Treaty, that the independent Bank is charged with ensuring price stability. Beyond that, the ECB will necessarily be the main co-ordinating institution for macroeconomic policy. The single monetary authority interacts, for good or ill, with eleven national governments, eleven fiscal authorities and eleven national labour markets. The game is rigged in an unfamiliar way.

Fiscal Policy, Labour Markets and the Difficulties of Inter-Country Adjustment within EMU

This chapter examines the macroeconomic performance of the euro area. It is widely agreed that this performance has been poor; low growth and poor productivity performance have been combined with high and rising unemployment and, especially in the ‘core’ countries, with budget deficits and increasing government debt. This poor performance on the real side has not, however, been matched by undershooting on inflation. It thus appears that the ‘trade-off between growth and inflationary pressure has become highly adverse within the euro area. The Lisbon ‘agenda’ of reforms to the European macro-economy — which was intended to improve the potential for non-inflationary growth — appears to be in tatters.