Central banks

A new monetarism

How to make economic policy fit for a world of low inflation

THE HISTORY of monetary policy is one of intermittent revolution. In the whole of the 19th century, constrained by the gold standard, America’s prices rose only 12%. After the second world war countries pegged their currencies to the dollar, which was in turn redeemable for gold. That system broke down in 1971 when it was abandoned by America. Its collapse ushered in the era of fiat currencies and preceded the inflation of the 1970s. Inflation-targeting was born out of that debacle and simultaneous intellectual advances by economists, who realised the importance of credible institutions. Over time more central banks committed to “flexible” inflation-targeting, meaning that in a crisis they could prioritise fighting unemployment.

Shortfalls in inflation, combined with very low interest rates, are causing another rethink today. In 2020 the Federal Reserve will report on a review of its targets and tools. The ECB is searching for new ways to fight low inflation in the euro area. Meanwhile economists are increasingly willing to question the dictum set out by Milton Friedman in 1963 that inflation is a monetary phenomenon. A decade of below-target inflation suggests that “what was previously treated as axiomatic is in fact false,” according to Larry Summers and Anna Stansbury of Harvard University. “Central banks cannot always set inflation rates through monetary policy.”

Central banking has also become more politicised. One of the few ideas to unite President Donald Trump with Alexandria Ocasio-Cortez, a left-wing congresswoman, is the belief that…