You might have hoped that central banking would be a fairly stable activity by now. The Bank of England has been around since 1694 while the Federal Reserve is over 100 years old. But the theory and practice of monetary policy are forever changing. In just the last 15 years we have seen the introduction of quantitative easing (QE), forward guidance and negative interest rates alongside a new emphasis on financial stability (post-2008).
Go back a bit and the big monetary policy ideas of the 1990s were inflation targeting (still in place) and the European single currency (also still going, though it has been a rocky ride!). The big idea of the 1970s and early 1980s was monetarism. The latest idea is the Fed’s switch to ‘average inflation targeting’ which is now worrying markets in the face of a surge in inflation. Or perhaps the latest idea is the suggestion that central banks should try to influence carbon emissions.
The Bank of England
What drives this perpetual change? I got to thinking about these issues when the US National Association for Business Economics (NABE) asked me to review Harold James’ excellent book on the history of the Bank of England (Making a modern central bank: The Bank of England 1979-2003). The review is just published and available free to read here.
The Bank of England became a ‘modern’ central bank between 1979 and 2003, in James’ words – meaning that it became an autonomous institution with an inflation target. Before 1997 monetary policy was set by the government with the BOE’s role only to advise and implement. The period 1979-1997 saw monetarist experiments, exchange rate ‘shadowing’ (to the Deutschmark) and Britain’s doomed membership of the Exchange Rate Mechanism. It also saw two boom and bust periods in the economy. At each point government ministers and central bankers confidently argued that they had found the Holy Grail – the best way to stabilise the economy. Yet each of these experiments ended in failure and the method was abandoned.
In most of the period covered by James’ book the key policy aim was to bring inflation down. When monetarism and exchange rate targeting did not work, or created more instability than desirable they were ditched for something else. New theory was then brought in to justify the changed approach.
Inflation targeting is the norm, for now
Inflation targeting with autonomous central banks became the norm around the world in the 1990s and is still, for now at least, the dominant framework. Yet it did not prevent the 2008-9 crisis, the worst downturn since WW2 until Covid. In the Bank of England’s defence, the average inflation rate in the UK since 1997 has been 1.9% (2.1% since 2008), so they have been very successful in meeting the inflation target itself.
After 2008 the main policy aim was to get the economy going again. Fortunately, inflation was threatening to run under the target so super-easy monetary policy satisfied both aims. But with rates at rock bottom what was needed was new methods. Enter quantitative easing.
The challenge in the next few years, not seen since the period covered in James’ book, could be rising inflation. Not super-high inflation but prints regularly in the 3-4% range. My guess is that the inflation targeting framework still has life in it. Reportedly, the one thing NOT on the agenda when the Fed conducted a review of its policy approach in 2019-20 was the 2% target. But this means that central banks will need to respond to higher inflation at some point with higher rates and tighter policy. I suspect they will be cautious and slow, which creates the risk that they need to be tougher in the end.
Nothing is forever
However, history suggests that monetary policy does not stay true to one approach for very long. So we can’t assume that inflation targeting will still be with us in 10 years time. Or perhaps it will be, but with new methods to influence the economy. Helicopter money, yield curve control, required reserve ratios are all possibilities. Or perhaps there will be new ideas not so far even discussed. Time will tell. Just don’t expect central banking or monetary policy to stay the same!