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A New Year, a New Central Bank Policy Angle?

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Central bank monetary policy has always focused on inflation. Or has it? We are so used to hearing about central bank targets and rate setting to control inflation that it seems 'twas ever thus…but in terms of economic history it's actually quite recent.

The 1970s era of stagflation is often pointed to as when the evils of inflation were first earmarked for eradication, but the Bank of England didn't actually get the freedom to target it until 1997 – before that interest rates were set by the government.

Germany is a better example for inflation geeks. The experience of Weimer Republic hyperinflation last century was enough to ensure that the Bundesbank became the most diehard inflation targeters ever, and its influence can be seen in the ECB today, although less so as the fiscal side becomes more relevant in the post-Lehman's era of low interest rates.

It's all about preservation of value. Pre-euro the Bundesbank Number 1, and indeed its only, priority was to endure inflation stayed low. The BoE has a 2 percent inflation target to meet, which it has missed in recent years.

Some commentators have suggested that inflation targeting caused the crash. That's a bit like saying Gordon Gekko (yes, a fictitious character) caused Black Monday in 1987. It's a valid point to suggest that only targeting inflation will not prevent a financial crash at some point, but only because nothing will prevent boom-and-bust cycles in the economy – they are endemic in the free market capitalist system.

(Read More: Why This May Be the Week the ECB Cuts Rates)

So given that crashes are endemic, should central banks target more than just inflation? The forthcoming change of Governor at the BoE has restarted this debate. The US Federal Reserve has a nominal GDP element to its objectives, although no official "target" as such.

Should other central banks follow?

Only if they keep it "informal". GDP statistics are always revised after first publication and it might be slightly reckless to actually "target" a formal GDP number. Perhaps one could just say" it should always have a ' ' sign in front of it" and leave it at that?!

Can one set monetary policy on the basis of what the GDP numbers are and what level they should be expected to be? There are so many factors driving this one bland statistic that it is almost gauche to think one could set interest rates to fine tune the number on a monthly or quarterly basis.

Even if that wasn't the stated objective, there is enough uncertainty to make the job very imprecise. Why not keep things as they are currently – an unspoken and unofficial approach that keeps rates low when the economy is in recession, and the inflation number can miss its target with none the wiser.

If simply targeting inflation alone is too last century for a central bank, what about adding unemployment targeting instead? At least the unemployment numbers are reasonably un-contentious, even if the definition of "unemployed" is always open to debate, and so can be focused on more clearly. So as well as a "2 percent" CPI target the central bank targets we could have, say, "less than 8 percent unemployment".

Many factors drive the unemployment statistic too, and in theory one could say monetary policy has more influence on "GDP" than "unemployment". But targeting something whose number is revised for months and even years afterwards seems one of the worst cases of trying to hit a moving target that one could imagine.

I read once that Wing Commander Robert Stanford-Tuck, one of the RAF's aces during the Battle of Britain, was an expert at "deflection shooting". That is the art of shooting at something that is moving in a different direction, angle and plane to you (air combat manoeuvring is of course a three-dimensional discipline). One expects this skill in fighter pilots – but in central bankers?

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Professor Moorad Choudhry is Treasurer,Corporate Banking Division at The Royal Bank of Scotland.

"The views expressed in this article are an expression of the author's personal views only and do not necessarily reflect the views or policies of The Royal Bank of Scotland Group plc, its subsidiaries or affiliated companies, or its Board of Directors. RBS does not guarantee the accuracy of the data included in this article and accepts no responsibility for any consequence of their use. This article does not constitute an offer or a solicitation of an offer with respect to any particular investment."