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Central banking in change of objective

By Hamish McRae

Published 18/12/2012

Principal shift: ECB president Mario Draghi
Principal shift: ECB president Mario Draghi

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% 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 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% and inflation was projected to remain below 2.5%, and that inflation expectations stayed contained.

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, 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.

In the UK, some sort of revision is necessary for two reasons. First, it did not prevent the Bank of England making the huge error of fuelling the most serious property bubble that has ever occurred. And second, the target has been missed so comprehensively that 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. 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 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 economic objectives of the government. Might we be asking central banks to do things for which they are not naturally suited?

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