Monetary policy has occupied a steadily more prominent role in economic management in the UK over the last 25 years. For much of the 1950s and 1960s, monetary conditions were seen essentially as a by-product of other policies which included, from time to time, a number of direct controls on, for example, wages, dividends and prices.

Monetary policy, too, depended on direct controls. For example, there were restrictions on consumer credit and bank lending in general. Mortgages were effectively rationed throughout the period. This was also a period in which the UK had restrictive exchange controls (abolished in 1979) and adhered to the Bretton Woods regime of generally fixed exchange rates against the dollar. The collapse of Bretton Woods in 1971, and the world-wide inflationary conditions of the 1970s, led to much closer attention to monetary policy in all countries.

In 1971, the UK moved to a more market-related monetary environment under a policy known as Competition and Credit Control. The former quantitative ceilings on bank lending were lifted and interest rates were allowed a larger role in the allocation of credit. This coincided with a period of fiscal expansion and rapid growth of demand in the economy, and monetary expansion was also rapid as banks increased their lending and competed in the interbank market for deposits.

A form of quantitative control was reintroduced in 1973 in the form of the Supplementary Special Deposit Scheme, also known as the ‘Corset’. It imposed penalties on banks whose interest-bearing deposits grew faster than a pre-set limit. The Corset was abolished in 1980.

For a period beginning in the late 1970s, monetary policy was conducted by reference to targets for broad money - and indeed in 1980 the new Government’s Medium-Term Financial Strategy set out broad money targets for several years in the future. Although the aim (price stability) and the instrument (the short-term interest rate) have remained virtually unaltered since, the framework in which monetary policy is conducted has undergone several changes.

It became clear in the early 1980s that broad money was sending misleading signals because its relationship to national income had changed quite significantly during the period, reflecting the liberalisation of the financial system and the particular strains of the recession. So by the mid 1980s monetary policy had become based on an assessment of a range of indicators rather than a single domestic money aggregate. Targets for broad money ceased in 1986 though its importance, along with a narrow money target, continued to be stressed. Narrow money (M0) came to be used as an indicator of economic conditions as it related to current consumer behaviour.

Operations in the foreign exchange market

For a period in 1987-88, monetary policy was constrained by the objective of holding the sterling exchange rate below DM3=£1. However, the low interest rates needed to maintain this were in place at a time of high domestic demand and thus inflation increased rapidly. In October 1990, the UK entered the European Exchange Rate Mechanism (ERM). The UK was obliged to keep sterling within pre-set limits relative to the other member currencies. To begin with this was helpful in bringing down both interest rates and inflation. However, exchange rate pressures grew as the contrast between the post-reunification boom in Germany and the recession in the UK persisted, and the UK was forced by market pressures to suspend its membership of the mechanism in September 1992.

On leaving the ERM, the Government adopted for the first time an explicit inflation target measured by the Retail Price Index excluding mortgage interest payments. Originally set at an inflation rate of 1-4%, with the objective of being in the lower half of that range by the end of the 1992-1997 Parliament, the target was subsequently revised to 2.5% or less. Although decisions on changes in interest rates remained with the Chancellor of the Exchequer, the Bank gained autonomy in publishing its economic appraisals (the Inflation Report, which has been published quarterly since February 1993) and in deciding the timing of interest rate changes. The monthly monetary meetings to review the level of interest rates were formalised and the minutes of the meeting were published two weeks after the subsequent meeting took place. These arrangements continued until May 1997 when the Chancellor announced the changes detailed on page 1. The Bank of England Act 1998 (which came into force on 1 June 1998) put the changes on a statutory footing.

Reproduced by kind permission of the Bank of England