The birth of inflation targeting: why did the ERM crisis happen?

In September 1992, the UK was forced to withdraw from the exchange rate mechanism of the European Monetary System, as it was unable to keep the value of the pound above the limit specified by the agreement. There are lessons from three decades ago for today’s bout of high inflation.

Central banks issue paper money. But what prevents them and the governments that establish them from overissuing it in the future and thus creating inflation?

The founders of the Bank of England were acutely aware of this credibility problem. They committed to not overissuing by making their currency convertible into gold. This prevented them from overissuing notes because as soon as they did, the Bank of England’s gold reserve would be drained. Convertibility of Bank of England notes into gold came to an abrupt and permanent end in 1931.

The Bretton Woods system, which operated from 1944 until the early 1970s, pegged the exchange rate of sterling and other participating currencies to the US dollar. In turn, the dollar was convertible into gold at $35 an ounce (Bordo, 2017).

This acted as a credible commitment for the Bank of England and the UK government to not inflate the currency. But the Bretton Woods system came to an effective end in August 1971 when the US president, Richard Nixon, suspended gold convertibility (Butkiewicz and Ohlmacher, 2021).

The end of this regime was followed by very high inflation in the UK (see Figure 1). Then began the tortuous search for a new nominal anchor to keep inflation in check (Chadha, 2022).

What was the ERM?

In an effort to reduce inflation and keep it down, the Bank of England and the UK government decided to try monetarism, a school of thought in macroeconomic policy-making espoused by the likes of Nobel laureate Milton Friedman (1960).

What this meant was that at the government’s behest, the Bank targeted the growth of the money supply and had to keep it within a predetermined range.

The approach was first introduced in 1977 by Labour chancellor Denis Healey and it subsequently became the centrepiece of Margaret Thatcher’s macroeconomic policy after the Conservatives won the 1979 election.

A policy based on monetary targets proved ineffectual at best because the rate at which money flowed around the economy (the velocity of circulation) was unpredictable. As a result, during the chancellorship of Nigel Lawson, monetary targeting was abandoned.

To anchor the currency, Lawson pursued an informal exchange rate peg with the German Deutsche Mark (DM). After shadowing the Deutsche Mark for several years, sterling formally entered the exchange rate mechanism (ERM) in 1990 at a rate of DM2.95 to the pound.

As Figure 1 shows, inflation declined markedly in the early 1990s. Joining the ERM helped the UK to achieve disinflation (James, 2020).

Figure 1: UK CPI, 1694-2021

Source: Bank of England

Exchange rate stability was important to the nations of Europe after 1945 because they traded so much with one another and countries that are bound by trade are less likely to go to war with one another. Consequently, the collapse of the Bretton Woods system meant that European economies were also looking for an anchor that would generate stable exchange rates.

They initially settled on the ‘snake in the tunnel’. This system required countries to keep their exchange rate movements within a 2.25% band with other member countries. Many large European countries, including the UK, failed repeatedly to keep the snake within the tunnel. Only Germany and a few small countries surrounding it were successful at maintaining their exchange rates.

The desire to end exchange rate volatility culminated in European countries forming the European Monetary System (EMS) in 1979. The EMS set up the ERM, which required that member currencies remain within the 2.25% band (6% for the Italian lira) and that each central bank was obliged to intervene in the foreign exchange market to preserve the band. Occasionally, countries had to adjust their exchange rate, but did so in negotiation with other ERM members.

Germany’s central bank, the Bundesbank, was central to the success of the ERM because the country’s disastrous hyperinflation of the early 1920s meant that it had a legislative mandate to keep inflation low. In effect, the Deutsche Mark was the anchor for other European currencies.

The ERM changed after 1987. First, the ERM was no longer a fixed-but-adjustable exchange rate regime. The stigma associated with devaluation now meant that it was a de facto fixed rate system (Higgins, 1993).

Second, the Single European Act of 1986 required capital controls to be removed across members by 1990. Capital controls – measures that limit flows of foreign capital in and out of the domestic economy – had played an important role in reducing downward pressure on exchange rates during the 1980s. Their removal resulted in a tension between domestic policy objectives and maintaining a stable exchange rate (Eichengreen and Wyplosz, 1993).

Third, the Maastricht Treaty of 1992 set out a timetable for the elimination of national currencies and a full monetary union for all members of the EMS, with the exception of the UK, which had an opt-out clause.

Why did the ERM crisis happen?

After a $22 billion intervention in the foreign exchange market by the Bank of England and a promise to hike interest rates from 10% to 15%, the UK government withdrew sterling from the ERM on 16 September 1992, a day that is remembered as Black Wednesday.

On the same day, the Italian government pulled the lira out of the ERM, and the Spanish government devalued the peseta. By May 1993, the Portuguese escudo and the Irish punt had also been devalued and in August 1993, the currencies remaining in the ERM were allowed to fluctuate within a 15% band.

The causes of the ERM currency crisis were both internal and external, but they are not mutually exclusive.

The internal cause focuses on the reunification of Germany in 1990. To support reunification, the government ran large budget deficits to augment the incomes of former East Germans and upgrade their infrastructure. Concerned about the inflationary consequences of those deficits and with its iron-clad commitment to price stability, the Bundesbank raised interest rates.

These high interest rates in the new ERM world with no capital controls drew funds towards Germany and away from other ERM members. The UK had to raise its interest rates to prevent capital outflows, which affected the UK’s housing market, competitiveness and economic growth (Eichengreen and Wyplosz, 1993).

Ultimately, the UK had no choice but to leave the ERM. Another factor in the UK’s departure was that it had entered the ERM at too high an exchange rate, a decision that was made because it allowed the country to maintain lower interest rates for holders of flexible-rate mortgages (Bean, 2003).

The external cause of the ERM crisis was that the exchange rates within the ERM were destabilised by the weakness of the dollar at the time (Eichengreen and Naef, 2020). The Deutsche Mark was regarded as the closest substitute for the dollar because of Germany’s low public debt, obsession with price stability, and liquid securities market. The weak dollar meant that funds flowed into the Deutsche Mark, causing it to appreciate with respect to sterling and other currencies.

Ultimately, the UK’s exit from the ERM was political. The French franc had also come under pressure, but Germany really needed France in the ERM, otherwise monetary union was not going to happen (Naef, 2022). In addition, France wanted to join the monetary union, whereas the UK had only joined the ERM as a way of getting its inflation under control.

The need for a new nominal anchor

The UK’s exit from the ERM now left it searching for an alternative way to anchor its currency. Within a matter of weeks of Black Wednesday, the government and the Bank of England had settled on inflation targeting.

Before the UK’s adoption in 1992, inflation targeting had been implemented by New Zealand in 1990 and Canada in 1991. Inflation targeting is characterised by a mandate for price stability, central bank independence, and central bank transparency and accountability (Bernanke and Mishkin, 1997; Svensson, 2010).

In 1992, the UK government issued a mandate for price stability. This stated that the target retail prices index excluding mortgage payments was 1-4% and that inflation should be in the lower half of the range by 1997. The target has changed a few times since 1997 and is currently set at the consumer price index being equal to 2%.

Central bank independence was not immediately adopted in the UK: that had to wait until Labour came to power in May 1997. But from 1992, there were checks on the ability of the government to base interest rate decisions on political rather than economic reasons (Bean, 2003).

The chancellor (Ken Clarke) and the governor of the Bank (Eddie George) had monthly meetings to set interest rates. The minutes of these meetings were published, and the governor was able to voice disapproval if he disagreed with the chancellor’s decision on interest rates. The meetings became known as the ‘Ken and Eddie Show’ (James, 2020).

Central bank transparency and accountability came from publication of the meeting minutes and of a new quarterly Inflation Report (rebranded the Monetary Policy Report in 2019) by the Bank. This report contains an analysis and forecast of inflation and growth trends.

After the granting of operational independence in 1997, transparency and accountability was enhanced by publication of the minutes of the Bank’s Monetary Policy Committee (MPC) meetings.

Has inflation targeting been successful at dealing with the problem of paper money? Figure 1 provides a resounding ‘yes’ to this question. Inflation targeting and its associated monetary policy institutions have prevented the government and the Bank from abusing their issuing power (King, 2004).

Lessons for today

The UK’s painful experiences from the end of the Bretton Woods system in 1971 until the adoption of inflation targeting in 1992 resulted in a consensus that price stability is the main objective of monetary policy and that central bank independence is the best way to achieve price stability. Two implications arise from this.

First, the Bank of England’s main task today is to reduce inflation. To do so will require it to increase interest rates irrespective of pressures from the government not to do so.

Second, the government will be tempted to interfere with the Bank’s policy-making to ensure that voters at the next election are not facing high borrowing and mortgage costs.

Thirty years of experience with inflation targeting suggest that the government should not infringe the Bank’s operational independence. To do so would be folly and would trigger another tortuous search for a new nominal anchor.