Mike Dolan

LONDON, (Reuters) – The pandemic’s seismic price shocks and extreme price distortions could end 30 years of inflation targeting by major central banks around the globe.

With headline and core inflation rates rising far beyond 2% target rates, and their highest levels in decades, central bankers have attempted to raise interest rates from historical lows or flag rate increases ahead. Despite insisting that inflation will remain below or close to those targets within the next two years.

U.S. Federal Reserve policymakers view their favorite measure, the core annual gains of personal consumption expenditures prices index – back to 2.1% in 2024 despite being twice its last year’s highest level in more than 30 years.

European Central Bank expects inflation to more than double in euro zone next year, while Bank of England anticipates inflation reaching 7.25% by the end of this year. However, inflation within the UK will plummet well below target after three years.

But the hawks will still be there, ready to demonstrate that they are in control and show the government and the people alike.

These forecasts may simply be based on the assumption of “normalization” in monetary policy over the short-term and return to prepandemic levels as supply skews in labour and energy markets decrease.

The problem raises questions about the viability of strict inflation targeting, which has been in fashion since the 1990s, as a guide to monetary policy.

Many believe that the increasing sovereign debt and rising household indebtness is a sign of deflation. This effectively raises inflation-adjusted borrowing costs over time, and could lead to prolonged depression. It’s simply not acceptable for most economists and governments.

The long-established norm of 2% may not be enough or risky. Since 2008’s banking crisis, most Western countries have been experimenting with deflation and sub-target inflation. This is why extraordinary loose monetary policies were introduced. These include bond buying to negative interest rates as well as other distortions that can affect asset prices.

Although it might seem the opposite of the problem it is, it shows the weaknesses in point targeting inflation.

There is no need to go to great lengths to stop economic activity by trying to deal with sudden inflation spikes caused by pandemic supplies jolts. Also, there are potential lingering price pressures.

US core inflation and Fed target – https://fingfx.thomsonreuters.com/gfx/mkt/zgvomjzzgvd/One.PNG

G7 inflation expectations – https://fingfx.thomsonreuters.com/gfx/mkt/akpeznxxbvr/Two.PNG

«PAST SELL BY»

Stephen Jen, EurizonSLJ hedge fund manager believes that this kind of pressure might be growing as the Fed remains hawkish while remaining “behind inflation curve” until the full extent of supply distortions is assessed.

Jen stated that “my sense is most economists might still prefer high inflation over low inflation.” The debate about whether central banks should set a higher target for inflation, such as 3% hasn’t even begun in earnest. But it will.

Financial markets do not believe that the central banks will be able to bring inflation back down to 2% in the near future. But inflation expectations on bond markets are 2.7% & 2.4%, respectively, over 5- and 10-year periods.

With its decision to abandon a target for point inflation in favor of an average of around 2% over the course of time, the Fed clearly has plenty of room. The Fed’s mandate clearly includes full employment, as well as stabilizing prices. This balances any tendency to stop inflation from affecting jobs.

The ECB lent its support in that direction as well, but neither the other central bank nor it has moved nearly as far. They are far less focused on meeting explicit price goals and their remits have remained much stricter.

The fears of overreaction to miss the target point on the upside are partly a reflection of the problem that was largely responsible for the end of inflation targeting fifteen years ago.

Many people accused the central banks in the 2000s of creating the credit bubble which burst dramatically in 2008. They did this by loosing monetary policy. This was because the headline inflation rates were very well managed. Other metrics were not taken into consideration.

Retrospectively, inflation targeting is still relatively new. It was only 10 years old at that time and had replaced many post-World War Two goals such as fixed exchange rates and the gold standard.

These had all failed and are equally prone to supply shocks, speculation.

One untested alternative, which has been suggested for many years, is that central banks target nominal GDP growth.

It allows central banks to set a specific goal that they can influence, rather than reacting too quickly to shocks in the supply chain. This is crucial for avoiding unreliable assumptions about future economic conditions and their potential.

Jim O’Neill is a former Chief Economist at Goldman Sachs, (NYSE:), and UK Treasury Minister. He says he’s a convert to Nominal GDP.

He said, “Single-point inflation targeting has been way over its sell date.”

The editor-at-large of finance and markets for Reuters News is the author. All views and opinions expressed in this article are the author’s.

(by Mike Dolan. Twitter (NYSE::): @reutersMikeD. Edited by David Evans