by Howard Schneider, Balazs Koranyi and William Schomberg
WASHINGTON (Reuters) – Major central banks, which credit their 2% inflation target with entrenching price stability, are seeing this monetary policy dogma face its first real test with the recent explosion prices.
By setting an inflation target, central bankers think they will give themselves credibility and better direct the thinking of households and businesses. The use of inflation targeting has spread across the developed world, from New Zealand in 1990 to the United States and Japan in 2012 and 2013 respectively, to Europe.
But since the onset of the COVID-19 pandemic and Russia’s invasion of Ukraine, this monetary policy framework is being shaken up like never before.
“Going forward, we may face a period of structurally higher inflation than in the past two decades. The deflationary impact of economic localization is dissipating and there will be inflationary pressures from global trade, climate transition, demography and politics,” said Claudio Boric, head of the monetary and economic department at the Bank for International Settlements (BIS).
Claudio Boric, however, is not in favor of raising inflation targets despite the recent surge in prices, which could be even more persistent than expected and make a return to 2% inflation more difficult to orchestrate.
At this stage, the greatest concern of the world’s big moneymakers is to lose their credibility if they do not respect the course of action that they have set for themselves.
“Is 2% some kind of magic number?” Lael Brainard, the vice chairman of the US Federal Reserve, said earlier this month. “Probably not. But that’s our number and we’re very committed to bringing inflation down to 2%… Achieving that target is at the heart of our overall monetary policy,” she added, echoing a sentiment shared by the central banks of the euro zone, the United Kingdom and Japan.
“Let me be absolutely clear, there are no ‘if’s or ‘buts’ in our commitment to the 2% inflation target,” the governor said last year. Bank of England, Andrew Bailey. “That’s our job and that’s what we will do.”
NOT THE “MOST SCIENTIFIC PROCESS”
At its monetary policy meeting on Tuesday and Wednesday, the Fed is expected, as every year since 2012, to commit to inflation at 2%, the “most consistent long-term” rate with its mandate given by the US Congress, namely price stability and full employment.
While the central bank has made significant changes to its “statement of long-term objectives and monetary policy strategy”, it has never questioned this target, on the grounds that a promise is a promise and that it can only be renegotiated at great risk.
Although it is now a global standard, the 2% figure is less the result of in-depth analysis or statistical estimation than the best estimate of a rate that would allow issuing institutions to reap the benefits of setting a goal, low enough for the people.
Coming out of the period of high inflation in the 1970s and 1980s, managers felt the need to consolidate their own credibility in the fight against rising prices and saw in setting a target a simple way of communicating to guide expectations and build confidence.
There is a broad consensus that a modest rise in prices is economically sound. It gives companies the possibility of adjusting the “real” costs of labor without slowing down hiring and gives central banks more leeway, thanks to higher nominal interest rates, to manage economic downturns through rate cuts rather than bond purchases and other less conventional measures.
New Zealand’s central bank, under political pressure in the 1980s to curb high inflation, was the first to put the idea into practice with a target of between zero and 2%.
“It wasn’t the most scientific process in the world,” said Michael Reddell, a former Reserve Bank of New Zealand economist. “No one had done this before us”.
“I personally think that number made sense based on history, experience, and research… It has served us incredibly well,” said New York Fed President John Williams earlier this month. “It has helped with transparency. It helps markets and people understand what our North Star is.”
However, the debate that remains is what will happen if this goal turns out to be more of an untouchable symbol than a realistic target.
Economists and central bankers do not expect inflation to moderate at a rapid and steady pace. Some even think that the current phase is the easiest with an initial drop in prices without serious consequences, particularly on the labor markets.
But despite the focus on returning inflation to 2%, officials also acknowledged that the debate could become more complicated as they assess the effect of interest rate hikes, past and future, on the economy. inflation and the economy.
A quick rate hike was “really important to demonstrate that resolve and to make sure people understand that 2% inflation is still the right anchor,” Lael Brainard said. “We are in a somewhat different position today… We are now in an environment where we have to balance the risks on both sides.”
Fed officials have predicted that their monetary tightening measures could result in the loss of 1.5 million jobs in the United States this year. If inflation proves more tenacious than expected, hitting the 2% target could be even more painful.
Although recent data suggests a “slightly better outlook” for an outcome where inflation slows to target without significant damage to jobs or growth, Lael Brainard said: “It’s a very uncertain environment and you simply cannot rule out worse compromises.”
(Reporting Howard Schneider in Washington, Balazs Koranyi in Frankfurt and William Schomberg in London; with Lucy Craymer, Michael Derby and Leika Kihara; French version Laetitia Volga, editing by Kate Entringer)
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