Following Wednesday's decision by the Fed to reduce its focus on the inflation target, M&G's Jim Leaviss makes the case that we're witnessing a sea change in central bank policy.
The level of real rates set by the Central Banks
The best evidence is obviously shown on the graph itself. Are central bankers hitting inflation targets? Not really – for example the Bank of England has only had CPI at or below the 2% target for 6 months in the last 5 years, and for much of that period it’s been above 3% (and above 5% at one point!). On latest data the UK, the Eurozone and the US all have negative real rates of 1.75% or higher. Western central banks are even considering setting negative NOMINAL interest rates. Only Japan of the major economies has positive real rates at the moment – although we think this might change dramatically, as I’ll discuss next.
Graph data: Office for National Statistics
The US refocus on the dual mandate
After three decades of inflation targeting, the Fed has been moving towards this new objective for a year or so now. First Charles Evans of the Chicago Fed started floating the concept of an unemployment target, then Janet Yellan (Bernanke’s probable successor) of the San Francisco Fed joined him, leading up to Wednesday night’s actions. This was pushing on an open door for Ben Bernanke who has written the following in his previous academic life…
Graph data: Bureau of Labor Statistics, inflation at CPI
Bernanke’s 4% inflation target for Japan
In this paper, Japanese Monetary Policy: A Case of Self-Induced Paralysis, written whilst he was at Princeton in 1999, Bernanke argues that the solution for an economy like Japan with a burst property bubble, broken banks, sluggish growth and deflationary pressures should be to target inflation of between 3% and 4%. Looks similar to the US situation, so why wouldn’t Bernanke think that this is the correct response from the Fed for the US?
Mervyn King’s softening stance on the inflation target
I guess actions speak louder than words, and the lack of actual inflation targeting in the UK for the last 5 years should tell you more than any speech, but I’d never heard the Governor soften his rhetoric until these words in this speech Twenty Years of Inflation Targeting this October. 'There may be circumstances in which it is justified to aim off the inflation target for a while in order to moderate the risk of financial crises'.
Japanese regime change, the 'Abe Trade'
This weekend Japan goes to the polls with opposition leader Shinzo Abe of the LDP favourite to emerge as the new Prime Minister. Japan has yet to recover from its bust, decades ago, and Abe wants to aggressively target growth. With deflation of 0.4% in Japan despite the BoJ’s 1% inflation target, Abe wants the central bank to do MUCH more. This would include raising the inflation target to 2% (or even 3%) and doing whatever it takes (more QE, currency intervention) to achieve that. This is a manifesto commitment that might get watered down at a later date – but having seen a BoJ member in Tokyo recently I get the feeling that a hike in its inflation target is inevitable.
Change in Europe
Hard evidence is more difficult to find, but with hawkish German ECB members like Axel Weber and Juergen Stark both resigning in 2011 ('It’s generally known that I’m not a glowing advocate of these (bond) purchases' – Stark) the ECB has been much more open to extraordinary balance sheet expansion (LTRO, SMP, OMT). And to more 'traditional' Quantitative Easing at a later date?