In a four-day period in mid-December, three seeminglyunrelated developments suggested that modern central banking is in the midst ofan historic change. The implications go well beyond academiaand policy circles. To the extent that this shift gains momentum – whichappears likely – it will affect economic performance, the functioning ofmarkets, and asset-price valuations.
The three developments began on December 12 in the UnitedStates, where the Federal Reserve, led by Ben Bernanke, announced that it willgo much further than doubling (to $1 trillion) the volume of market securitiesthat it intends to buy in 2013 in order to stimulate the economy. The Fed alsoleft no doubt that it will maintain its foot onthe accelerator until the US unemployment ratedeclines significantly, at least to6.5%, and as long as inflation is contained at or below 2.5%.
According to most analysts, the novelty in the announcementwas the Fed’s willingness to be explicit about its quantitative policythresholds and, therefore, about the future course of its monetary policy. Butmy reading of what the Fed announced (and what Bernanke said in the subsequent press conference) suggests that the innovation goes beyondthis.
The Fed is taking very different approaches to thespecification of the two quantitative thresholds: unemployment will be based onhistorical data, while inflation will be based on the Fed’s own projections.This subtle difference has interesting operational effects. Most important, itprioritizes the unemployment objective over the inflation target. Thisrealignment 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 inflationary1970’s, when President Jimmy Carter appointed Paul Volcker to lead the Fed. Inorder to prevent pathological inflationarydynamics from becoming embedded even more deeply in the structure of theeconomy (including through wage indexation),Volcker dramatically changed the policy stance and made inflation public enemynumber one. The equivalent of today’s policy rate rose to 22% as he launched abold anti-inflationary crusade, accepting significant upfrontcosts for gains down the road.
This “Volcker moment” was, as students of economic historyknow, the catalyst not only for “winning the war against inflation,” but alsofor a multi-decade shift in conventional wisdom about central banking. Mostimportant, inflation targeting and independence from the fiscal authoritiesbecame core features of mainstream policy – a requirement for any countryseeking the macroeconomic stability deemed crucial for sustained economicgrowth and high rates of job creation.
I suspect that historians one day will view last month’sFed announcement as the catalyst for a similarchange in conventional wisdom – both in America and around the world. They willconclude that two factors motivated Bernanke: persistently high US unemployment– which, like the inflation problem that Volcker faced, risks becoming deeplyembedded in the structure of the economy – and virtualparalysis on the part of other policymaking agencies.
There are almost five million “long-term unemployed”Americans, constituting more than 40% of total unemployment. Millions more havedropped out of the measured labor force altogether. And about a quarter of16-19-year-olds in the labor force are unemployed. All of this risks seriousskill atrophy. And the unemployed young face theadditional risk of becoming a lost generation.
It is therefore doubly surprising that, aside from the Fed,America’s policymaking agencies are essentially missing in action. The problemis not a lack of leadership from President Barack Obama, who has put forwardseveral proposals to address the country’s unemployment problem, including acomprehensive jobs initiative. Rather, the problem is a polarized Congress that has taken no major economicdecisions in the last few years – other than missteps(like the fiscal cliff) that risk tripping theeconomy into recession.
With political paralysis likely to continue in 2013,notwithstanding occasional agreements, the Fed will be busy implementing theparadigm shift for central banking. And the impact could well spread. Whichbrings us to the two other developments in that four-day period inmid-December.
A few hours after the Fed’s announcement, news came thatthe British government was open to considering a change in the Bank ofEngland’s policy anchor. Unlike the Fed, the BoE’s sole objective for years hasbeen price stability, with no additional employment mandate. If the target ismissed repeatedly, as it has been, the governor must send a public explanatory letter to the government. Now it lookslike politicians may be looking to offload ontothe Bank responsibility for generating economic growth and jobs.
The third development occurred in Japan, where thenewly-elected Liberal Democratic government of Shinzo Abe, commanding atwo-thirds parliamentary majority, is pressing the Bank of Japan to stimulategrowth – a “discussion” that looks set to evolve into something much moreassertive.
In short, expect central banks to devote greater attentionto unemployment. And it is a good thing that the official sector is paying moreattention to joblessness – a very good thing. Yet, unfortunately, this shiftwill not solve a problem that eats away at thesocial fabric of any society.
As much as Bernanke and others wish otherwise – and as much as bickeringpoliticians seek to dump policy responsibilities on others – central banks donot have the proper tools to deal with the component of the unemployment crisisthat results from insufficient investment in education, training, and physicalcapital. Likewise, they cannot fix debt overhangs, repair broken homefinancing, or address medium-term fiscal-reform challenges on their own.
The best that central banks can do is to buy time, albeitat an increasing cost, for other policymaking entities to get their acttogether. If this window closes, the monetary-policy paradigm shift now visiblein the US, Britain, and Japan would risk a damaging loss of credibility andpolitical independence for institutions that are critical to well-managedeconomies.