In a four-day period in mid-December, three seemingly unrelated developments suggested that modern central banking is in the midst of an historic change. The implications go well beyond academia and policy circles. To the extent that this shift gains momentum—which appears likely—it will affect economic performance, the functioning of markets, and asset-price valuations.
The three developments began on December 12 in the United States, where the Federal Reserve, led by Ben Bernanke, announced that it will go much further than doubling (to $1 trillion) the volume of market securities that it intends to buy in 2013 in order to stimulate the economy. The Fed also left no doubt that it will maintain its foot on the accelerator until the US unemployment rate declines significantly, at least to 6.5%, and as long as inflation is contained at or below 2.5%.
According to most analysts, the novelty in the announcement was the Fed’s willingness to be explicit about its quantitative policy thresholds and, therefore, about the future course of its monetary policy. But my reading of what the Fed announced (and what Bernanke said in the subsequent press conference) suggests that the innovation goes beyond this.
The Fed is taking very different approaches to the specification of the two quantitative thresholds: unemployment will be based on historical data, while inflation will be based on the Fed’s own projections. This subtle difference has interesting operational effects. Most important, it prioritises the unemployment objective over the inflation target. This realignment of the Fed’s dual mandate, which I have called the “reverse Volcker moment,” has been evident for a few months.
Let me explain by going back to the end of the inflationary 1970’s, when President Jimmy Carter appointed Paul Volcker to lead the Fed. In order to prevent pathological inflationary dynamics from becoming embedded even more deeply in the structure of the economy (including through wage indexation), Volcker dramatically changed the policy stance and made inflation public enemy number one. The equivalent of today’s policy rate rose to 22% as he launched a bold anti-inflationary crusade, accepting significant upfront costs for gains down the road.
This “Volcker moment” was, as students of economic history know, the catalyst not only for “winning the war against inflation,” but also for a multi-decade shift in conventional wisdom about central banking. Most important, inflation targeting and independence from the fiscal authorities became core features of mainstream policy—a requirement for any country seeking the