There have been two major watersheds in the evolution of monetary policy in the post-war period. The first watershed was reached with the realisation that on account of its overtly political nature it was difficult to pursue countercyclical macro-economic policy using the fiscal tool. Entry was easy but exit was not. There was also a realisation during the stagflationary 1970s that when the source of inflation lies in the volatile commodities sector, the Phillips curve breaks down and the central banks’ chief monetary policy instrument gets blunted. The pole position in macro-economic management was consequently taken by ‘independent’ central banks who started targeting core rather than headline inflation. The second watershed was reached when monetary policy setting by central banks became rule-bound rather than discretionary. The most widely used rule was the Taylor rule.
We may now be at a third watershed in the evolution of monetary policy.
Following the recent global financial crisis, John B Taylor argued that a contributory factor was that US monetary policy was too loose as it deviated from his eponymous rule. What were the factors underlying this deviation? The story begins with the sharp decline in consumer price index-based inflation in both developed and developing countries over the last two decades. According to IMF data, it averaged under 7% in developing countries between 2002 and 2010, as against 38.4% between 1992 and 2001. In developed countries, it fell by about 20%, from 2.4% to 1.9%. On the basis of this data the IMF in its World Economic Outlook of April 2013 concluded that ‘inflation-targeting’ by central banks had been eminently successful.
Inflation-targeting, however, was never an end in itself. It was the canary in the gold mine that central bankers watched to set the equilibrium interest rate at which incomes are optimally distributed between savings/investment and consumption so as to keep the economy growing at the production possibility frontier, or its potential growth rate. If core consumer price inflation were however to lose its sensitivity to the business cycle, the targeted inflation would also cease to ensure macro-economic stability. This is precisely what happened. Core inflation remained remarkably stable, despite sharp fluctuations in growth and periodic fluctuations in commodity prices. Savings declined, while investment and consumption increased, leading to an ever-widening US current account deficit (CAD). The Phillips curve became unstable all over again. The problem was much deeper than a simple deviation from the Taylor rule,