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In the second half of the 1980s, the PSBR moved into surplus which was partly due to the flow of payments to the government as a result of the privatisation of public sector corporations. In the second half of the 1980s occurred a shift in attention, especially

in medium-sized countries, away from monetary aggregates whose past performance

had cast doubts on their predictability, towards stabilising the exchange rate since past misalignments in the foreign exchange market had led to increasing concern by

Monetary Policy in the United Kingdom

the authorities'll. Furthermore, in the case of the United Kingdom, the exchange rate attracted growing attention in the light of a possible entry into the ERM, after broad money targets had been abolished. High interest rates in the United States and a strong appreciation of the dollar increasingly biased interests rates in the UK by forcing the authorities to maintain them at a higher level than they would have done

otherwise. In September 1985 in the Plaza Agreement, the G5 resumed an active co­

ordination effort to reduce the pressure by driving down the dollar. Soon after, the

dollar started to depreciate strongly and concern grew about the consequences of a massive depreciation. In February 1987, the G7 agreed in the Louvre Accord to stabilise the dollar by installing a loose system of 'reference ranges' within which the currencies were to be maintained. The specific guidelines set out in the Accord for the monetary policy of the participants, however, did not require changes in existing UK policy. At the end of 1987, interest rates were cut in response to the collapse of the

world stock markets in October. In March 1987, an informal arrangement was made

to constrain sterling within a narrow trading range with respect to the Deutschemark, which was just below 3 DM/£. Whenever the pound tended to rise above this range, the authorities intervened in the foreign exchange market or reduced interest rates. This coincided with a period of upward pressure on sterling and excessive domestic

demand, which in the face of growing inflationary pressures, made it increasingly

difficult to retain the low level of interest rates necessary to maintain the 'peg' to the DM. Consequently, this policy was abandoned in March 1988. British monetary policy between 1985-87 can be described as having been significantly influenced by an effort to narrow the range of sterling fluctuations against the DM in anticipation of a possible UK membership in the EMS *‘a n d h r in an ejfort to control Inflationary expectations by drawing on investor confidence in the

The strong appreciation of sterling was viewed by the authorities as a major factor behind the depth of the UK recession.

During the 1985-87 period, the growth of M3 was extremely high and 1989 experienced a resurgence of inflation. In the budgets from 1987/88 to 1992/93, no target ranges for broad money aggregates were set and the ranges set for Mo had merely an 'illustrative' character^^. However, in the 1988 budget report, the authorities stated that Mq had proved a reliable indicator of monetary conditions'^^. Furthermore, although no broad monetary target had been set, the authorities continued to take

broad money developments into account for the assessment of the stance of monetary

policy. Goodhart^S argued that, although the authorities maintained Mo as a target aggregate, there has been no case where the development of this indicator was primarily responsible for a policy instrument shift, apart from a few occasions where

Mq was considered before policy measures were taken. In 1990, the British economy went into a recession initially caused by a sharp fall in domestic demand^6. The RPl

peaked at over 10 per cent in 1990 and than declined gradually, reaching under four per cent in the first quarter of 1992.

On the 6 October 1990, the United Kingdom entered the Exchange Rate Mechanism.

ERM membership was viewed by the authorities as device to create credibility for

British monetary policy. The Governor stated in November 1992 that

“it certainly offered a very visible sign o f our commitment to price stability - a sign that could be understood, and which would thus influence favourably expectations in the private sector

The precondition for sterling membership had always been stressed by the authorities as being twofold; The convergence of the UK inflation rate to an average EMS

Mq is in the short-term exclusively demand-determined and has therefore no apparent short-term

causal role. (BEQB, February 1995)

24 Goodhart (1992, p. 143) remarks that "indeed we have had some monetary targetry ever since 1985, in the form o/ M q, though this, I believe, has mainly represented a jig leaf to disguise the actual fa ct o f the abandonment o f monetary targetry, a fig leaf which enabled the Chancellor to say that he

never gave up monetary targetry".

25 Goodhart (1992)

26 Domestic demand fell between the second quarters of 1990 and 1991 by 4.7%. (BEQB, August 1992)

Monetary Policy in the United Kingdom

country rate of inflation and the chance for the UK authorities to observe the working of the EMS after exchange controls had been removed. A satisfactory fulfilment of these conditions was perceived as essential in order to secure a ’smooth entry'. However, prior to sterling's entry, the rate of inflation did not meet the first precondition. Although in the period 1987-90 exchange rate controls were still in force, the ERM appeared to rely to a lesser extent on the use of this instrument, which showed the system's ability to function successfully even without these controls.

The UK suspended its membership on the 16 September 1992, after turbulent market

conditions had necessitated a heavy official purchase of Sterling. The Governor pointed out that, due to the increasing divergence between the domestic policy needs in Germany and elsewhere in Europe, the constraints of the system forced Britain into unduly disinflation, which involved the risk that the UK economy would suffer unnecessary damage^®. Britain's exit from the ERM resulted in a loss of counter- inflationary credibility, although as King (1993) argued, this loss was small.