Is central banking about to make another of its once-in-a-generation shifts in direction, this time away from focusing on current inflation?
The question arises because three of the world's main central banks are changing their objectives. One has already done so. The European Central Bank, under its Italian president, Mario Draghi, has in effect shifted its principal aim from keeping inflation under 2 per cent to saving the euro. As he put it "we will do whatever it takes", which as he then demonstrated included the commitment to buy the sovereign debt of distressed eurozone members.
The second change in a central bank's objectives was announced last week in a speech by Ben Bernanke, chairman of the Federal Reserve Board. It was likely that the Fed would keep official rates near zero as long as unemployment remained above 6.5 per cent and inflation was projected to remain below 2.5 per cent, and that inflation expectations remained contained. As far as I recall this is the first time a major central bank has included an unemployment target, even as a short-term objective, as a guide to policy.
The third example has not yet happened, but the probability has risen following the appointment of a new Governor of the Bank of England. Mark Carney, speaking in Toronto last week, pondered whether central banks might drop inflation targets in favour of nominal GDP.
The idea of a money GDP target is not new. It was implicit in the money supply targeting adopted by the British authorities during the 1980s as a way of controlling inflation, before we switched to an inflation target. But though we regard them as normal, inflation targets have only a 20-year history, and though one is core to the ECB, the US has never had an explicit target.
In the UK, some sort of revision is clearly necessary for two reasons. First, it did not prevent the Bank of England making the huge policy error of fuelling the most serious property bubble that has ever occurred in the UK. And second, the target has been missed so comprehensively that most people no longer take it seriously.
Whether a nominal GDP target would be better is another matter. Some argue that it would enable the Bank to follow a more growth-oriented policy now. You can see what has happened to money GDP over the past decade, together with the stunning slump in 2008/9, in the right-hand graph. Actually since 2010 money GDP has grown pretty much along its previous profile, though of course the lost ground has never been made up: the blue line is way below the red one. The problem we have had during the recovery, though, is that inflation has been way above target, so too much of the growth in money GDP has been absorbed in higher prices rather than real growth.
Commenting on the possibility of a shift to money GDP targeting, Fathom Research notes that it "is effectively a dual mandate for a central bank, as it implies they must focus on both inflation and real output … It is a reversal of the mainstream philosophy of monetary policy for the past 20 years: one target; one instrument; clearly defined rules guiding the use of that instrument."
So no panacea. At any rate, for different reasons, three important central banks are in a state of change. The ECB wants to focus on saving the euro; the Fed on getting unemployment down; and the Bank of England (probably) on getting growth up. Since these objectives are quite different, you have to ponder just what should be the role of a central bank, apart from supporting the general economic objectives of the elected government, or governments, in question. Might we be asking central banks to do things for which they are not naturally suited?
If you look back at the way central banking has evolved, the original purpose was to raise money cheaply for governments, usually to enable them to finance wars. Through the 19th century, other functions accrued, in particular their role as custodians of the currency and as lender at last resort to the banking system. The balance of these objectives has shifted over time. In time of war it is obvious, and at the moment central banks and governments are using war-time policies to drive down the cost at which governments can borrow. This has been described as "financial repression" – using various measures to force down yields below inflation and to encourage people (or more likely pension funds) to buy bonds that are bound to lose value.
We have an example of that now. The main graph, from Barclays, shows the real return on US and UK government securities over the past half century. As you can see there was a long period of financial repression until the end of the 1970s, when inflation and interest rates rose so high that the policy had to be reversed. That gave a great deal for people who bought government securities. But now that period seems to be coming to an end and Barclays projects negative returns for the next five years.
We don't know how negative these might be, but the idea that central banks are going to move away from the anti-inflation priority of the past 30 years should make bond investors very wary.
Three cheers for GDP as a measure of our well-being
There has been so much criticism of the idea of growth in gross ometic product (GDP) as a measure of economic well-being that it is good to see a robust assertion that actually it is rather a good way of working out which countries are doing well and which are not.
It comes in the magazine CentrePiece, which pulls together research at the Centre for Economic Performance at the London School of Economics.
In "Hooray for GDP", Nicholas Oulton argues that it retains its usefulness as a measure of output and an indicator of human welfare. People's choices between work and leisure show that they value higher consumption in absolute terms, not just relative to others. And rising GDP remains a policy objective that the majority of people support.
This comes in a week when stories were published showing that the UK had slipped down the European league for living standards. This calculation is not just GDP per head but adjusts for state benefits and so on. We were number four behind Luxembourg (pictured), Norway and Switzerland, but now we have slipped behind German and Austria too.
Looking at the way the story was reported as more bad news for Britain, I rather see Mr Oulton's point.