Inflation targets

The UK first introduced inflation targets in 1992 following sterling’s suspension from the exchange rate mechanism. The government wanted an inflation target to be the ultimate objective of monetary policy having opted to move to a floating exchange rate system.

The European Central Bank (ECB) has targeted 2% inflation since it was created in 1999. The United States Federal Reserve (“The Fed”) has a dual target for inflation and economic growth.

Because the Bank of England (BoE) is operationally independent, the UK government sets the inflation target (2%). There is an upper (3%) and lower (1%) band to the target, the lower band reflects the importance attached to preventing the UK economy entering a period of sustained price deflation

An inflation target is designed to:
1. Help control inflation expectations
2. Provide a transparent target / anchor for monetary policy
3. Lock in price stability for the economy and enhance confidence

The UK inflation target switched from RPI to CPI in December 2003 – and the inflation target has not so far included asset prices e.g. property prices and share prices. For most of the time since the Bank was made independent in 1997, inflation has been within target range. 2008 saw inflation ‘overshoots’ and an exchange of letters between the Bank of England Governor and the Chancellor! In 2009 retail price inflation started to drop sharply and by the spring it was negative, the first price deflation in the UK since the 1960s. By the end of 2009 CPI inflation was well below the 2% target.

Critics of the inflation target argue that a failure to include asset prices in the chosen measure led to interest rates being too low during the property boom and this caused the asset price bubble to be too strong.