There have been three important developments in central banking in the past week, which together indicate that their approach to inflation targeting, one of the few features of pre-2007 policy orthodoxy that has survived the financial crisis, may now be subject to radical change. (See Robin Harding on the “quiet revolution” at the central banks.) It is greatly premature to declare that inflation targeting is dead, but things are clearly on the move.

In the UK, the incoming Bank of England governor Mark Carney has suggested nothing less than the abandonment of the short-term inflation objective altogether, and has mooted the possibility of a nominal GDP level target, which is a beast with very different stripes. In Japan, the new Abe government intends to impose a higher (2 to 3 per cent) inflation target on the central bank, which can probably be hit only by pushing the yen lower.

In the US, there has been a clear shift in the Fed’s policy reaction function, or “Taylor Rule”, increasing the weight placed on unemployment and reducing the weight on inflation. The nature and importance of the Fed’s policy shift has not yet been fully understood, because it was not really spelled out by Chairman Bernanke in his press conference this week.

The Fed’s legal mandate from Congress is, of course, to promote “maximum employment, stable prices, and moderate long-term interest rates”, and nothing has changed in that regard for decades. However, in the early years of Chairman Bernanke’s reign, he obviously wanted to emphasise the long-term inflation objective as much as possible, and this came to fruition in January with the announcement of a formal 2 per cent target for consumer price inflation (as measured by the PCE deflator).

Furthermore, since the policy actions of the Fed usually seemed to place a much higher weight on the inflation objective than the unemployment objective, the actions of the US central bank were very similar to those of other flexible inflation targeters. Frequently, the Fed was criticised for not even allowing a temporary overshooting in inflation relative to target, whatever the level of unemployment at the time.

The January 2012 statement on policy objectives was initially seen as being important because it formalised the inflation target for the first time. Less noticed was the fact that it also stated very clearly that the FOMC’s estimate of unemployment in the long term could be viewed as the committee’s view of “maximum employment”, and therefore it could be treated as an unemployment target. In addition, the statement unequivocally stated that short-term deviations of both inflation and unemployment from their ultimate targets should be given equal weight in setting monetary policy.

The importance of this was that the Fed did not view the 2 per cent inflation target as a short-term ceiling. The central bank could justify aggressively easing monetary policy to get unemployment down, even if inflation moved temporarily above target. This thinking was then developed further by Charles Evans at the Chicago Fed, who suggested that the Fed should set an interim guidepost for the unemployment rate, subject to an inflation ceiling not too far away from 2 per cent. And, last month, Vice-Chair Janet Yellen indicated that optimal policy, responding to high unemployment rates, might allow a temporary overshoot in inflation in order to bring unemployment down more rapidly.

All this thinking has clearly been influencing policy for some time, and it explains the very aggressive easing in Fed policy this year. Following the September FOMC meeting, the Fed embarked on monthly purchases of long-term debt running at $85bn a month, an unprecedented rate outside the 2008-2009 financial rescue operation. Since this is almost certain to continue throughout 2013, the Fed’s total balance sheet, including an estimate of the effects of Operation Twist, will behave as shown in the first graph [1]:

If we express these figures in relation to GDP, we derive an estimate of the cumulative extent of quantitative easing (ie, the stance of monetary policy), and the change in QE (ie, the change in the monetary stance) since 2008 [2]:

Note that both the overall stance of policy and its rate of change have been aggressively eased in recent months. Why has this happened? Can it be explained by the fact that inflation and unemployment are deviating further away from their respective targets? No, it cannot.

The third graph shows the deviation of unemployment above target and the gap between the inflation target and the actual inflation rate. Upward movements in the graph indicate that there is a need for more monetary stimulus and vice versa:

Based on these deviations from targets, which have been diminishing in the case of unemployment, the Fed might have been expected to be slowing the level and pace of monetary accommodation, but in fact it has done precisely the reverse. By far the most likely explanation for this development is that the Fed is now placing a much greater weight on unemployment in setting policy than it has ever done in recent years.

By the same token, the tolerance of short-term deviations of inflation relative to the 2 per cent target has increased, though apparently with a ceiling of 2.5 per cent, measured by the FOMC’s inflation forecast 12 to 24 months ahead. The FOMC has not simply made a technical change in its communications policy, it has decisively changed the “Taylor Rule”, which guides its decisions.

The chairman did not spell out this change in the Fed’s reaction function in his press conference last week, but virtually everything he said was consistent with this interpretation. Furthermore, he partially explained the shift when he said that it was urgent to get unemployment down before it started to become permanently embedded in the labour market, and before there was a risk of another cyclical downturn in the economy.

For much of his career, Mr Bernanke could safely be characterised as a flexible inflation targeter. That may still be true, but the markets should recognise that he has significantly altered the weight he places on unemployment in his policy reaction function [3]. We do not know whether the Fed has the necessary tools to reduce unemployment, but there is no room for any doubt that it is going to try to do so, and try very hard indeed.



[1] We have assumed that Operation Twist had the same effect as purchasing $700 billion of 10-year duration treasury securities, which is the estimate given by the New York Fed.

[2] The size of the balance sheet is only a very approximate indicator of the amount of duration risk which the Fed has removed from private hands, which is the figure we should really be using here.

[3] A more formal econometric analysis, reaching the same conclusion, has been published this weekend by Lotfi Karoui and Sven Jari Stehn at Goldman Sachs. It is recommended for readers with access to GS research.

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