Chart 1  Chart 2  Inflation close to target despite protracted Lower bond yields not always associated decline in short term interest rate with higher equity prices  2  Note: * adjusted for changes in leverage Source: Bank of England and ONS  Source: Bank of England and Datastream  The decline in the natural rate of interest At around the time that inflation targeting began, the economist John Taylor proposed a simple representation of rate-setting by the US Fed – the so-called “Taylor rule”. This suggested that variations in real short rates were well explained, empirically, by movements in the “output gap” and inflation. Allowing for these real short rates looked relatively stable. The word “rule” wasn’t meant prescriptively. In this context it simply meant “reaction function” – a description of the way US policy rates had in practice, and over a particular period of time, responded to the economy. But as the concept took hold, many began to interpret the relationship not just as a description of what central banks had been doing but as an indicator of what they should do. In particular, the Taylor rule cemented a view that only cyclical factors could justify deviating from a particular level of the policy rate.
In this respect it’s interesting to look at a passage from Keynes’s Treatise on Money, written in the teeth of the Great Depression in December 1930: We cannot hope for a complete or lasting recovery until there has been a very great fall in the long-term rate of interest throughout the world … Yet [that] is likely to be a long and a tedious process, unless it is accelerated by deliberate policy. Of specific remedies two [are] appropriate. The Bank of England and the Federal Reserve Board might reduce the rate of  4  4  A policy surprise is defined here as the difference between the announced Bank rate and a proxy for market expectations embodied in meeting-to-meeting interest rate swaps on the day of the MPC decision. BIS central bankers’ speeches  interest to a very low figure, say ½ per cent. At the same time these institutions should pursue open-market operations à outrance. That is to say, they should buy long-dated securities either against an expansion of Central Bank money or against the sale of shortdated securities until the short-term market is saturated. So QE certainly isn’t a novel idea (in fact the US Fed conducted large scale asset purchases in 1932, something that Milton Friedman5 later suggested was critical in stabilising the economy later that year). And, as Keynes suggests, the purpose was to “accelerate” a decline in long-term interest rates that would otherwise have been a “tedious” process.