Media Briefings


  • Published Date: May 2014

UK monetary policy has become more effective since the Bank of England was given its inflation targeting mandate, according to research by Colin Ellis, Haroon Mumtaz and Pawel Zabczyk, published in the May 2014 issue of the Economic Journal. In particular, the new study finds that unanticipated changes in the policy interest rate after 1992 appear to have a bigger impact on inflation, bond yields, equity prices and exchange rates than they did previously.

The researchers argue that these changes are consistent with policy becoming better at managing inflation expectations. This suggests that to preserve the benefits of greater transparency, policy-makers should respond strongly whenever there are signs that the credibility of the inflation target is starting to erode.

Over the past five decades, the UK has undergone major structural changes. These include dramatic shifts in macroeconomic policy and globalisation-induced changes in competition, technological advances and financial innovation. One question this raises is whether the channels through which monetary policy affects the economy have changed over time and what that might mean for how policy should be conducted.

Arguably, many models of the economy, including those often used in policy institutions, abstract from related issues, by assuming, in effect, that the economic relationships – including the way various types of disturbances are transmitted – are fixed over time. The set-up underlying this study tackles these issues head-on, not only by allowing for time-variation in economic relationships, but also by using a large amount of disaggregated data to allow for sharper inferences.

The model developed in this study focuses on the transmission of unanticipated changes (so-called ‘shocks’) in demand, supply and monetary policy. Some of the findings suggest that the widespread practice of ignoring time-variation doesn’t automatically lead to wrong conclusions, as there appears to be little evidence of the transmission of demand or supply shocks changing over time. Crucially, this is not the case for unanticipated changes in monetary policy.

More specifically, the researchers provide evidence that prior to 1992, there was little distinguishable impact on inflation from policy becoming unexpectedly tighter. Since that time, however, the response of inflation to the same policy tightening has become more negative and persistent.

The 1992 change date, which broadly coincides with the introduction of inflation targeting, is not hard-wired into the model. But it naturally emerges as one consequence of the underlying specification, which allows for time-variation in a very flexible fashion.

The study also provides evidence that bond yields and equity prices have responded more strongly to policy shocks since 1992. But there is no evidence of any change in the response of GDP or other real activity measures to monetary policy shocks, be it in aggregate or disaggregated data. The authors’ interpretation is that the greater transparency associated with inflation targeting may have reduced the activity costs associated with anchoring consumer prices.

Taken together, these results imply that monetary policy now has a stronger impact on broad underlying inflationary pressures, which is encouraging, as these changes, rather than say relative price shocks, are what theory suggests policy-makers should be focusing on.

The researchers also argue that the main impact from the introduction of inflation targeting in 1992 occurred via inflation expectations. Taken at face value, this suggests that policy-makers should respond strongly if the credibility of the inflation target starts to erode.

Finally, the results also suggest that it is important to take explicit account of time-variation in the transmission of monetary policy shocks, as failure to do so could potentially lead to costly policy mistakes.


Notes for editors: ‘What Lies Beneath? A Time-varying FAVAR Model for the UK Transmission Mechanism’ by Colin Ellis, Haroon Mumtaz and Pawel Zabczyk is published in the Conference issue of the Economic Journal.

Colin Ellis is at Moody’s. Haroon Mumtaz is at Queen Mary, University of London. Pawel Zabczyk is at the Centre for Central Banking Studies at the Bank of England.

For further information: contact Romesh Vaitilingam on +44-7768-661095 (email:; Twitter: @econromesh).