Inflation Targeting and Financial Conditions: UK Monetary Policy during the Great Moderation and Financial Crisis

Abstract

In this paper, we investigate the interest rate setting behaviour of the Bank of England (BoE) over the 16 year period covering both the Great Moderation and the 2008-9 Global Financial Crisis and Great Recession. We contribute to the literature by using the BoE’s own inflation projections in our estimations. Also, we develop a novel measure of the output gap to encapsulate the array of real variables that the Monetary Policy Committee of the BoE reviews. In order to assess the BoE’s responsiveness to financial markets, we estimate a new financial conditions index that covers a wide range of financial indicators that feature in the Inflation Report. Our study provides some new insights into the BoE’s monetary policy behaviour. We show that the BoE was concerned not only with price stability but also output, employment and financial conditions during the Great Moderation. In contrast to previous studies, we find that the BoE responds relatively less to financial conditions and relatively more to inflation projections when the 2008-9 Global Financial Crisis and Great Recession period is included.

Keywords: Monetary policy, Financial Conditions, Economic Activity Index

JEL Classification: E44, E52, E58