The future of Central Banking

Following the Global Financial Crisis, central banks and central bankers have been the focus of public discussion and debate probably more than ever before in their history. Topics that would previously only have interested a select few are aired in the newspapers, on blogs and in the political debate. Terms that even the professionals barely understood ten years ago, such as Quantitative Easing and the Zero Lower Bound, have become commonplace and part of the general discourse.  It has been an interesting time to comment on the normally dry-as-dust subject of central bank monetary policy.

For much of the last 8 years, the debate has focused primarily on what central banks were doing to combat the threat of a second Great Recession – the extraordinarily low interest rates, the aggressive use of their balance sheets and so on.  But as the period of extreme monetary policy draws to a close, the discussion is beginning to look forward, and to what the future policy framework for central banking should be.

Over the coming weeks we hope to have a series of articles examining this debate and looking at what markets can expect in the next few years from the central banking community.  And we will start with one of the most fundamental questions of all:  what should the central banks’ target for inflation be?  After all, it is logical to agree on what level of inflation central banks should aim for, before discussing how they should aim for it.

The question of the optimal inflation level for an economy is one which long pre-dates the Financial Crisis.  Policymakers have realised for many years that although high inflation is definitely damaging, it is not the case that one should aim for a complete absence of all inflation.  Partly this is because the cost to an economy of trying to squeeze the very last drop of inflation out of the system often exceeds the benefit from doing so, and partly this reflects the fact that in any economy, a small amount of inflation is actually useful in providing some flexibility and in facilitating relative price changes between different goods or services.

As inflation targeting became more commonplace in central banking – broadly speaking, from the 1990s onwards – a consensus emerged that the optimal level of inflation in a mature developed economy is around 2%, and most central banks that have a public target for inflation will be aiming for this figure or thereabouts.  The experience of the last 5-7 years in most major economies, though, is that inflation has usually been below this target and often some way below, with the more pressing challenge for central banks since 2009 being to avoid outright deflation (ie, falling prices).

With many central banks missing their inflation targets for years in a row – the extreme example is from Japan, where the Bank of Japan have not achieved sustainable inflation of 2% for over two decades now – it is not surprising that an argument has been taking place among economists about whether the 2% target is still optimal or whether it should be revised.  What is rather more unexpected however is that there is a considerable voice for the inflation target to be not lowered but raised.

The idea of raising the inflation target was first seriously put forward in 2010 by Olivier Blanchard, the then Chief Economist of the IMF. His rationale was primarily that, as average real interest rates in the economy have fallen (from a common 2-3% pre-2007 to more like 1% at most today), there might not be enough space with the traditional 2% inflation target to lower interest rates in the next economic downturn without hitting the zero lower bound (ZLB), below which, it was assumed, nominal interest rates could not go. 2% inflation and 1% real policy rates generate a steady-state equilibrium official rate of 3%, and since the Federal Reserves has on average over the past three decades cut interest rates by 300bps in a downturn, this would in normal circumstances leave very little space for monetary policy easing when it was needed.

Blanchard’s conclusion was that an overall target of 4% for inflation would be almost neutral on economic activity – the consequences of inflation at 4% are, he argued, only very marginally more negative than inflation at 2% – but would make the operation of monetary policy much easier and more effective in downturns, a trade-off he considered on balance to be net positive over the business cycle.

Most central bankers have hesitated to support Blanchard’s call publicly, not least because while they were struggling and failing to get inflation even as high as 2%, it could have looked perverse to publicly set an even higher target.  As one central banker commented, “a higher target would only be missed by a larger amount, and would have drawn further attention to how unsuccessful we are proving in the current circumstances”.

More fundamentally, there are both presentational and operational reasons for central banks to be cautious about making the change.  Firstly, central banks have spent a lot of time and effort over the past 25 years, explaining why 2% is the right target for inflation[1] and embedding the number in the public consciousness.  A change to 4% would involve explaining why 2% was wrong and – perhaps more difficult – why 4% is right. It is at least possible that central bank credibility would suffer in the process.

Furthermore, while historically 2% inflation has shown itself to be relatively stable, by contrast 4% has not shown itself to be a stable rate. Moving to a 4% target therefore also risks greater inflation volatility – and while the IMF’s work aimed to show that a stable 4% inflation rate would be only marginally damaging to an economy, there is little doubt that an unstable or volatile inflation rate around 4%, say varying between 2% and 6%, would have much more adverse effects.

And perhaps most worrying, if in the future 4% inflation is in turn deemed insufficient for whatever reason, what is next? 8% perhaps, a rate at which the value of money halves in value every nine years?

But this is not only a question of shifting the actual target. As noted above, one of the reasons for suggesting a higher inflation target is because of the risk of hitting the ZLB. But, seven years after the introduction of unconventional monetary policy and with negative interest rates having been tried in at least six economies (Sweden, Denmark, Switzerland, Euro Area, Japan and Hungary), we now know that the ZLB does not exist. There is indeed in all probability an ELB (effective lower bound) – but firstly we don’t know where it is, and secondly, it is certainly lower than minus 0.75%, since that is where Swiss official interest rates have been for well over 2 years, and the perceived negative impacts of interest rates below zero (such as hoarding of cash, disruption of the banking system) have so far not been apparent.

Moreover, the call for higher inflation targets implicitly assumes that central banks have only one instrument, the policy interest rate. In fact, as we now know, there is a plethora of potential instruments, ranging from the tried – forward guidance, quantitative easing of different kinds, lending incentive schemes etc – to the untried, such as helicopter money and the direct monetisation of government debt.

In fact, the same call actually also assumes there is only one proper central bank target, namely inflation. But that is now also too simplistic. Almost all central banks now either explicitly or implicitly have to consider macro-prudential stability. However defined, this is unlikely to benefit from a higher (and probably more volatile) rate of inflation.

None of this means that central banks should never change their targets or their policy regimes or that they should stubbornly stick to policies regardless of their success. But it does imply that it should be done carefully and with much thought given to whether it is necessary and better to change than to not change.

We conclude that the central banking community is unlikely to heed the IMF’s call for higher inflation targets any time soon.

In fact, we think it more likely that central bank mandates will change in a totally different direction in the not-too-distant future. Independent inflation-targeting central banks were on the whole successful during the Great Moderation of 1990-2007, though whether this was thanks to their own efforts or due to a benign global environment is still a moot point. And it gave them an aura of infallibility and all-knowingness, which in turn allowed them to operate with almost total autonomy.  But, as we have predicted in earlier papers[2], central banks and central bankers risk losing this semi-divine status once their infallibility is brought into question by failures to control or generate inflation, and with it will be at risk their much prized independence of action.

A more likely direction for central banking in the coming years, we think, will be an increase in both the range of their duties (possibly moving more central banks closer to the Federal Reserve’s “twin mandates” of controlling inflation but also promoting growth and economic activity) and in the closeness of political oversight of their activities.

We will examine these influences and pressures on central banks, and some of the potential ways we expect central banking to develop in response, in further articles in this series.


[1]              The exact form of the target differs slightly between central banks;  for example while the US Federal Reserve and the Bank of England aim for inflation “of 2%” as a point target, the European Central Bank try to ensure inflation is ”below but close to 2%”, the Bank of Canada aim for it to be “between 1 and 3% and averaging 2%” and the Reserve Bank of Australia aim for it to be “between 2 and 3%”.  But no major central bank targets 4% at the moment, so for all of them, adoption of a 4% target would require a policy change.

[2]               See “Bubble, bubble, toil and trouble – central banking in the 21st Century” , by Gabriel Stein, Lombard Street Research Monthly Review, 2006; and “Central banks and the return of inflation”, by John Nugée, Laburnum Consulting article, September 2006