Are we seeing a quiet shift of policy focus at central banks? For most of the past three decades, central bankers have concentrated on price stability, often with explicit inflation targets. There is increasing evidence, however, that inflation might no longer be top of policymakers' minds.
Cast your mind back to the 1970s and early 1980s for a moment: fixed income assets were virtually non-investable. Rampant inflation resulted in negative real returns for bond investors, provoking buyers' strikes in the UK and undermining the Government's attempts to rein in the bloated budget deficit.
Since then, inflation across the Western world has been tamed. The reasons for this are many: higher productivity thanks to new technology and the increased globalisation of world trade, as well as demographic improvements that have seen a larger ratio of workers to non-workers.
We should also recognise that central bankers have played their part, led by Paul Volcker as chairman of the US Federal Reserve. If you plot a graph of the relationship between inflation and interest rates prior to and after his appointment in 1979, you can see just how much the world has changed.
In the decades before Paul Volcker's arrival at the Fed, inflation consistently ran ahead of interest rates. After his appointment, the relationship is inverted – interest rates have almost always been above inflation – helping, no doubt, to trigger the long bull run in bonds.
The influence of central banks was enhanced by the growing power of international financial markets, which demanded greater transparency from policymakers. The publication of underlying forecasts for macroeconomic variables and regular comment on the economy became market fixtures.
Central bank credibility was imperative to influence the behaviour of economic agents. In consequence, many central banks gained independence from their governments so that they should not be swayed by domestic politics (voters tend to appreciate a reduction in interest rates).
Targets – particularly inflation targets – were introduced to ensure that central bankers took the appropriate monetary stance. Any deviation from these targets would be quickly assessed by market participants and they would re-price securities accordingly. An inflation rate of 2-3 per cent quickly became an article of faith.
Then came the financial crisis that started in 2007. The evaporation of liquidity and the near-collapse of the banking system appear to have sparked a quiet rethink of central bank policy. The new policy may not have even been articulated by the bankers themselves, let alone broadcast to the world in general. But there is clear evidence of a shift in emphasis.
In short, the focus has moved from inflation towards labour markets. In one sense, they are ahead of the politicians. As employment prospects in Western economies continue to look bleak, citizens will demand that central banks weigh up not only the economic costs of a particular monetary policy stance, but also the social impact. It's not that inflation targeting will be abandoned, but rather that unemployment rate targeting will also be considered a principal task of those charged with setting interest rates in major developed economies.
If there is anything that keeps central bankers awake at night, it is unemployment rates. These have deteriorated markedly since 2008. Youth unemployment is at all-time highs across the UK and Europe, while under-employment rates – when a worker is employed but not in their desired capacity, whether in terms of compensation, hours or level of skill and experience – have worsened to levels not seen since the Great Depression of the 1930s. Central bankers know that high unemployment is not conducive to economic growth. More importantly, they are also well aware that it eats away at the fabric of society. The UK could well see more of the riots that broke out on city streets this summer. There is a real danger that a generation of young adults have their life chances permanently harmed unless employment prospects improve.
Explicit targets for unemployment outcomes have already been raised as a new policy proposal. Charles Evans, president of the Chicago Federal Reserve Bank and a member of the Federal Open Market Committee, has openly advocated a US unemployment target of 6 per cent and an inflation tolerance rate of 3 per cent.
In this context, it is easier to understand why the Bank of England has missed its inflation target for nearly two years. Unless you believe that Mervyn King and his colleagues are incompetent, they must have a solid reason for tolerating CPI inflation of 4.2 per cent when their target is 2 per cent. Indeed – with inflation rates in the US and Europe running just 1.5 per cent and 1 per cent above their respective central bank targets – the Bank of England could be considered somewhat ahead of its peers in identifying that the focus of monetary policy must now surely be on reducing unemployment.
Where one central bank leads, others are likely to follow. After surprising markets with an interest rate hike in April 2011, the European Central Bank has been forced to change course, cutting rates in November and December last year. The US Federal Reserve has also committed to keeping interest rates at current low levels at least until late 2014. Monetary authorities in major developed markets, it seems, are increasingly coming to the conclusion that the zero-rate environment and quantitative easing must persist until we get people back to work. They also know that the debt burdens, public and private, built up during the bubble decade need to fall in real terms. Given the parlous state of most government balance sheets in the developed world, reflation via monetary policy is the only policy tool left.
Savers, including increasingly influential Asian sovereign wealth funds, obviously won't like this radical rethink of central bank policy. For this reason, Western central bankers and governments will be reluctant to advertise, or perhaps even admit, the regime change currently taking place. But they will have little choice in pursuing it if they are to avoid abandoning a generation of young people.
Jim Leaviss is a former Bank of England economist and head of retail fixed interest at fund manager M&G Investments