The 2% target: the touchstone of central bank inflation in the post-pandemic era

WASHINGTON/FRANKFURT/LONDON, Jan 30 (Reuters) – Top central bankers, who credit the use of a 2% inflation target with anchoring decades of stable prices, are facing the first full test of the effectiveness of this approach to monetary policy once prices have exploded, and how rigorously they will apply it if the damage to their economies intensifies.

By announcing an inflation target, central bankers feel they are bolstering their credibility and focusing household and business planning to help keep inflation under control. It’s a concept that seemed supported by the facts as the use of inflation targeting spread across the developed world, from New Zealand in 1990 to Europe and the United States and Japan. in 2012 and 2013.

Those decades, until the end of the first year of the coronavirus pandemic in 2020, saw inflation largely contained.

But they also coincided with trends in globalization, technology, and demographics that helped. Since the start of the pandemic and the continued invasion of Ukraine by Russia, these same forces can now push prices in the other direction, challenging this shared monetary policy framework with a kind of adversity to which it has never been confronted and, with continued supply shocks, may find it difficult to adapt.

“Going forward, we may face a period of structurally higher inflation compared to the past two decades. The deflationary impact of localization is dissipating and there will be inflationary pressures from global trade, climate transition, demographics and politics,” said Claudio Boric, head of the monetary and economic department at the Bank for Settlements. International, Central Bank Coordination Group.

Still, Borio said he was not in favor of raising central bank inflation targets, a view that has spread among key policymakers – from hawk to dove – despite equally widespread concerns. that the recent surge in inflation could be even more persistent than expected and the return to 2% all the more difficult to conceive.

At least at this point, central bankers’ biggest worry is the loss of credibility if they don’t toe the line they have drawn for themselves.

“Is 2% some kind of magic number?” said US Federal Reserve Vice Chairman Lael Brainard at a forum earlier this month. “Probably not. But that’s our number, and we’re very committed to getting inflation down to 2%… Achieving that target is at the heart of our overall monetary policy,” Brainard said, a sentiment echoed at the bank’s headquarters. central from Frankfurt to London to Tokyo.

“Let’s be clear, there are no ifs and buts to our commitment to the 2% inflation target,” Bank of England Governor Andrew Bailey said last year. “That’s our job, and that’s what we will do.”

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The Fed is expected at its two-day policy meeting this week, as it has done every year since 2012, to recommit to 2% inflation, the rate “most consistent over the long term with the Fed’s statutory mandate.” Federal Reserve” of the US Congress to promote “stable prices” alongside maximum employment.

Although the U.S. central bank made major changes along the way to its “Statement on Long-Term Objectives and Monetary Policy Strategy,” it never put the inflation target itself in play. on the grounds that a promise is a promise, and only renegotiated at great risk.

Yet the 2% figure, as suggested by Brainard, is of no particular significance on its own. Although this is now a global standard, it was less the product of careful analysis or statistical estimation than a better estimate of an inflation rate that would capture the benefits that central banks see this by setting some sort of target, while remaining low enough that the public, in effect, would not notice.

Emerging from the high inflation environment of the 1970s and 1980s, policymakers recognized the need to shore up their own credibility in the fight against inflation and viewed commitment to an announced inflation target as a easy-to-communicate medium to both steer audience expectations and, assuming they remained loyal, established trust.

At the same time, they wanted a level of inflation consistent with long-term price stability, which former Fed Chairman Alan Greenspan in a mid-1990s debate defined as a “state in which expected changes in the general price level do not effectively alter household affairs or decisions.”

While some inflation hawks still argue that the level would be zero, there is a broad consensus that a modest rise in prices is healthy for an economy. It gives companies a way to adjust “real” labor costs without holding back hiring, and it gives central banks more leeway, through higher nominal interest rates, to manage economic downturns with interest rate cuts rather than bond purchases and other less conventional measures used in the past. key rates have reached zero or close to zero.

New Zealand authorities, under political pressure to stem high inflation in the 1980s, first put the idea into practice with an initial target of between 0% and 2%.

“It wasn’t the most scientific process in the world,” said Michael Reddell, a former economist at the Reserve Bank of New Zealand. “No one had done this before us.


Still, it stuck. It has spread. And that probably helped.

“I personally think that number made sense based on all of the history, experience and research… It’s served us incredibly well,” said New York Fed President John Williams. , earlier this month. “It helped with transparency. It helps the markets and people understand what our North Star is.”

The yet-to-be-launched debate, however, is what will happen if the North Star turns out to be less of a destination and more of an untouchable symbol – if the path back to 2%, already expected to be slow , comes to a halt in the post-pandemic economy.

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Economists and policymakers do not expect inflation to fall in a rapid, linear fashion. Some even see the current phase as the easier part, with consensus among officials on the need for higher interest rates and an initial slowdown in inflation underway without any serious damage, especially to markets. work.

Policymakers insist they will bring that last mile back towards their inflation target.

But despite all the attention on returning to 2% inflation, they also acknowledged that the debate could become more complicated by studying how inflation and the economy react to the interest rate increases approved so far, and others are in preparation.

Last year’s rapid rate hikes were “really important in demonstrating that resolve and making sure people understand that 2% inflation is still the right anchor,” Brainard said. “We are in a somewhat different position today… We are now in an environment where we are balancing the risks on both sides.”

Fed officials have projected that their tightening efforts could cost 1.5 million American jobs this year. If inflation turns out to be more rigid than expected, hitting the central bank’s 2% inflation target could mean even more losses.

While recent data suggests “slightly better prospects” for an outcome where inflation slows to target without deep damage to jobs or economic growth, Brainard said, “it’s a very uncertain environment and you just can’t rule out worse compromises”.

Reporting by Howard Schneider; Additional reporting by Lucy Craymer, Michael Derby and Leika Kihara; Editing by Dan Burns and Paul Simao

Our standards: The Thomson Reuters Trust Principles.

howard schneider

Thomson Reuters

Covers the US Federal Reserve, monetary policy and economics, graduated from the University of Maryland and Johns Hopkins University with previous experience as a foreign correspondent, business reporter and local Washington Post staffer.

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