Bringing inflation under control

20 years of Bank of England independence

In 1997, the government granted independence to the Bank of England to set monetary policy.

But what does that mean? And why does it matter?

Below is a brief history of how the UK brought inflation under control.

From the 1970s to the early 1990s, inflation was high and volatile. It was 3.2% in 1986 and went up to 9.5% just 4 years later.

This made it difficult to predict what prices will be in the future, making it harder for firms and households to plan their spending.

Peterborough Station, entrance and Great Northern Hotel 1992 cc-by-sa/2.0 © Ben Brooksbank

At times during this period, rather than targeting inflation, interest rates were being used to target the value of the pound – the UK being in the Exchange Rate Mechanism or ERM from 1990.

In 1992 the UK left the ERM and changed the way it used monetary policy – it could use interest rates to influence inflation, not the value of the currency.

Norman Lamont, Chancellor 1990-1993, on 'Black Wednesday'

The government became one of the first countries to introduce an inflation target, after New Zealand (1989) and Canada (1991).

At the same time, new monthly meetings between the Chancellor and the Governor of the Bank of England, together with the publication of meeting minutes, provided greater transparency around decisions over the interest rate.

Both inflation-targeting and improved accountability helped lower inflation and keep it within its target range.

Market Weighton High Street, 1995 cc-by-sa/2.0 © Ben Brooksbank

However, monetary policy was not free of political influence. This undermined the credibility of the inflation target, as people believed the government could always lower rates before an election.

This helps explain why inflation expectations were consistently at the top of the target range during this period.

Westminster, 1996: Palace of Westminster in autumn cc-by-sa/2.0 © Ben Brooksbank

In 1997, the government granted the Bank of England control over monetary policy.

The Bank was now able to set interest rates without input from ministers, and was accountable for achieving the inflation target set by the Chancellor.

After Bank of England independence was announced, expectations for inflation dropped immediately.

Inflation between 1997 and 2003 averaged 2.4%, very close to the government target.

The Railway Pub - Top of Caerphilly Town in Nov 2001 cc-by-sa/2.0 © Eddie Reed

Inflation expectations were less volatile than the 70s or 80s, and also very close to the 2% target.

This highlights people's confidence in the UK achieving its inflation targets.

While inflation was low in 2015 and early 2016, it has risen more recently and moved above the 2% target.

However, inflation expectations have remained close to the average of the past 5 years.

The Bank of England forecasts that inflation will fall gradually back to target over the next two years, reaching 2.2% in 2019.