A question that many people are asking, Kevin Boscher looks at where this target came from and whether it remains a valid option for central banks.
In the past week, we have seen interest rate cuts from the Bank of Canada and ECB with other central banks, including the Fed and Bank of England, expected to follow suit in the next few months. With headline inflation having fallen significantly in many developed and emerging economies over the past year or so, we finally appear to be in the early stages of a monetary easing cycle which is expected to see interest rates fall significantly over the remainder of this year, and into 2025. This is despite reported inflation in some economies, such as the UK and US, still above the central bank’s 2% target. With this in mind, it is worth considering whether a 2% inflation target is still appropriate and sensible in a global economy which is undergoing an enormous amount of change and uncertainty.
Where did 2% come from?
To begin with, it is interesting to remind ourselves that a 2% inflation target started with the New Zealand central bank in 1989 and was suggested as part of its move to independence. The BoE then adopted this target in September 1992, after exiting from the ERM and experiencing a sharp currency devaluation. Other central banks then followed. Whilst there isn’t any strong or empirical evidence for why the inflation target should be at this level, it is generally accepted that long-term economic growth is best achieved by sustaining price stability through controlling inflation. Also, it makes sense to provide a safety margin against the risk of deflation and ensure that monetary policy remains effective given the natural limits to how low interest rates can go.
It is generally understood by policymakers that deflation is bad since it can lead consumers to spend less now in anticipation of lower prices, can push businesses to lay off employees or cut wages to maintain margins and profitability and it makes existing debt more expensive for many borrowers. It is also very difficult to fix since interest rates can only really fall to zero and central banks are forced to print money via Quantitative Easing (QE), which results in other problems. This has been evidenced by the experience of Japan, where the economy is just about breaking free of deflation after 30 years of trying. The post-GFC decade also saw the US and Europe experiencing deflationary trends, which resulted in an extended and unprecedented period of near zero interest rates and a huge increase in money supply via QE.
It is equally true that an inflation rate running “too hot” is also bad for an economy, since rapid or uneven rising prices inevitably reduces the purchasing power of some consumers and leads to falling real wealth and incomes. It can also result in a wage-price spiral whereby workers demand higher wages, which forces companies to increase prices, which then repeats. This risk is currently accentuated by the fact that workforces are shrinking in many major economies, adding to the upward pressure on wages. Inflation can also distort the purchasing power (value) over time for recipients and payers of fixed interest rates, i.e. cash and bonds. In theory, and indeed in practice over recent times, it is easier for central banks to crush inflation through higher interest rates and tighter monetary policy, but this takes time and is often at the expense of a recession or a significant decline in economic activity.
Revisiting the Fire vs Ice debate
As I have highlighted previously, there is an active debate at present between whether the global economy is transitioning back towards the powerful secular disinflationary forces that prevailed prior to the pandemic (Ice) or whether we are moving to a period of higher inflation similar to the 1970s and early 80s (Fire). I can still make a strong case either way, but the truth is that nobody knows since we have not been through a pandemic followed by a war and inflation shock before and there is no economic model that can accurately predict what comes next. Factors in favour of the ice outcome include an ageing demographic, whereby economies tend to save more and spend less, continuing (and maybe accelerating) technological innovation and a global excess of savings over investment. From the fire perspective, in addition to demographic-related wage pressures, it is likely that many governments, including the UK, will need to operate a looser fiscal policy (taxation and spending) moving forward. This will mean bigger fiscal deficits, as they tackle the challenges of a fracturing global economy (energy and food security plus increased defence spending), climate change, an ageing demographic (more spending on healthcare, pensions & welfare) and income and wealth inequality.
If developed country governments are running bigger fiscal deficits, then this will present a real challenge for central banks given the record levels of debt in the global and individual economies. In a heavily indebted economy, there is a natural ceiling beyond which interest rates can’t go without breaking something, causing a debt deflationary or inflationary bust. We have seen clear evidence of this with the UK pension crisis in September 22, US regional banks last year and current problems in European and US commercial property markets. Given this, central banks may need to practice financial repression and keep interest rates lower than the macro backdrop would naturally dictate, thus adding to upward pressure on inflation.
One way around this might be for central banks (and governments) to target higher nominal growth through a higher inflation target (say 2-4% or nominal growth of 4-5%). They can argue that this would help governments as they tackle these challenges, boost long-term growth (nominal) potential, help ease income & wealth inequality and lessen the risk of deflation. It would be more difficult to openly admit that higher nominal growth would also help to “inflate away the debt” but this would be one of the objectives.
Another potential solution would be a new cycle of increased capital investment by business, which could have the impact of increasing potential growth through rising productivity but in a non-inflationary way. Indeed, we appear to be in the early stages of such a trend in the US and elsewhere, where the combination of “onshoring”, changing supply chains, rising costs and new technologies are encouraging companies to embark on a capital spending boom. The last time we saw such a development in the US, was in the mid 1990’s where the US economy was able to grow in excess of 4% in real terms at the same time as inflation and interest rates were falling. The major catalyst for this development back then was the growth of the internet. This time, it is likely the advent of AI as well as cloud computing, Biotech and other new technologies. This would certainly be a very positive development for the global economy and markets.
Inflation affects us in different ways
It is also worth pointing out that we all view and experience inflation differently depending on our financial circumstances and to some extent, our age. For those on lower incomes and without significant liquid savings or assets, rising inflation is really problematic since it leads to financial hardship as tough choices have to be made between spending on food, housing, utilities etc. It can also be tough for retirees if pensions fail to keep up with rising prices, obviously depending on their financial circumstances. For this segment of the population, inflation can often feel much worse than the headline numbers suggest. For wealthier citizens and particularly cash/asset rich ones, high inflation can actually be beneficial as cash and other financial assets (such as equities) tend to deliver higher returns. Inflation will also impact businesses in different ways as we have seen of late. For example, companies with pricing power and a dominant market position are usually able to pass on their rising costs to the consumer and benefit from higher returns on their strong cash flows, thus maintaining margins and profitability. For other companies, where it is not possible to do this, margins, profits and financing costs can all be negatively impacted. Finally, inflation can vary significantly from country to country depending on how an economy calculates inflation and what items are included in the basket, for example mortgage interest payments, rental equivalents, taxes, travel, hospitality etc.
We are about to find out whether the Fed, BoE and other central banks are sufficiently confident in their inflation outlook to embark on a new cycle of interest rate cuts. This is not straightforward given the fact that inflation, and service sector inflation in particular, is still proving sticky. They also need to assess whether their current policy is too restrictive and risks a slowdown in growth or a rise in unemployment. The Fed, in particular, has a dual mandate of maintaining full employment and controlling inflation. Their task is made even more challenging by the fact that they have very little conviction in their forecasts given the hugely changeable and uncertain macro backdrop. They also need to remember that monetary policy and interest rates can be used successfully to control demand and ensure it remains in balance with supply, albeit with a considerable time lag, but it is much more difficult for central banks to control commodity or energy related inflation using monetary policy.
We are in the early stages of a new monetary easing cycle
I am optimistic and believe that the Fed and other central banks can cut rates over the next year or two and achieve a “soft landing” whereby economies avoid recession and activity actually starts to strengthen as policy is eased. Beyond this timeframe, it will really depend on whether we are returning to ICE or moving towards FIRE. This should be a positive environment for both bonds and equities and now would appear to be a good time to increase exposure to risk assets. Cash will remain a very important asset class and we are not about to return to a zero-rate world but returns will fall as rates decline. I’ll cover this in more detail in my next review later this month.
As for whether a 2% target for central banks remains a valid option given the rapidly changing global economic and geo-political environment, I think it is perhaps time to think about introducing a wider range (say 2-3%) or targeting nominal growth instead. Maybe this will become a reality after the next UK or global economic or financial crisis hits, as it surely will.
