Should we move the Bank’s inflation target to 3%?
An epic battle has been under way for more than 18 months. Some say it is being fought with the wrong weapons, others that the outcome is not for us to determine but depends on international factors. Still, it continues. The battle is to get inflation back down to its official target of 2 per cent.
While inflation has fallen from its peak of 11.1 per cent last October to 6.8 per cent last month, there is a bigger journey to get from here to 2 per cent than that achieved so far. There is nervousness in government about where we go from here — particularly around next month’s figures, which will determine by how much state pensions and other benefits go up next April. Household energy bills are heading in the right direction, but petrol prices are rising again.
Meanwhile, the collateral damage from fighting inflation with higher interest rates — which can now be seen in the housing and labour markets and will spread elsewhere — is building.
The latest “flash” purchasing managers’ survey, published a few days ago, dropped well below the key 50 level and was headlined “UK private sector output falls at fastest rate since January 2021”. That month, to remind you, marks the start of the third Covid lockdown, when monthly GDP fell by nearly 3 per cent. Other countries are seeing a similar impact.
Is the battle worth the fight? Why do we have an inflation target, and why does it have to be 2 per cent? Would it make much difference if it were higher, say 3 or 4 per cent, if it meant less interest rate pain?
This debate has been running for a long time but remains hot. A few days ago, Jason Furman, former head of the White House Council of Economic Advisers, wrote in The Wall Street Journal that the Federal Reserve, the US central bank, should lift its target from 2 to 3 per cent when it next reviews its strategy.
“Whatever considerations led policy- makers to conclude that 2 per cent was the right number in the 1990s would lead them to consider something higher, like 3 per cent, today,” he wrote.
A bit of history might be useful. The UK came to have an inflation target by accident just over 30 years ago. When the pound was forced out of the European exchange rate mechanism (ERM) on “Black” Wednesday in September 1992, the central plank of the government’s economic policy was removed.
In its place, an inflation target was introduced. Legend has it that the process was helped by a couple of economists from New Zealand on secondment at the Treasury. Three years earlier, New Zealand had pioneered an inflation target — and an independent central bank got the job of meeting it.
The UK target, for inflation to be kept in a 1 to 4 per cent range, paved the way for the Bank of England to be made independent in 1997. Its target was 2.5 per cent for a measure known as RPIX: the retail price index excluding mortgage interest payments. This was chosen instead of plain RPI because, otherwise, the Bank would have been targeting a measure that mechanically went higher every time interest rates were increased.
Things became simpler with the shift to a CPI (consumer prices index) target in the early 2000s. The target was reduced from 2.5 to 2 per cent, reflecting the fact that, over time, RPIX inflation was about half a percentage point higher than CPI inflation. That 2 per cent also became the consensus figure among central banks, though the UK target is set by the government, as since 1992.
Why, despite the current difficulties, think about changing the target? After all, and this may surprise you, in the first 25 years of Bank independence, until the spring of last year, CPI inflation averaged exactly 2 per cent — bang on target. The very high inflation of the past year or so has tarnished the record, so the average since 1997 now stands at 2.4 per cent. Disappointing, but not disastrous.
For economists such as Furman, one of the strongest arguments for a higher target is that, while it seems a distant prospect now, few expected we would enter a long period with official interest rates at zero, or close to it, when 2 per cent became the inflation target; stimulating their economies meant central banks had to resort to quantitative easing (QE) and other unconventional measures. It is easy to forget now that two years ago, before it embarked on the current run of raising rates sharply, the Bank was busy putting negative interest rates into its policy toolkit. A higher target would give central banks more leeway, and more ability to cut rates when necessary, without even thinking of negative rates.
There is another argument, which in the case of the UK is more compelling. It is that, in spite of the record of the past quarter of a century, I am not sure that 2 per cent ever became the natural or “normal” rate of inflation in the UK.
I say this because if you look at inflation over the first 25 years of independence, when the rate averaged 2 per cent, goods price inflation was a low 1.1 per cent, while service sector inflation, a better measure of domestically generated price pressures, averaged 3.3 per cent. Goods prices were held down by the China effect and the initial price-reducing impact of the internet — factors that have faded in importance. Neither prevented goods price inflation from surging over the past 18 months, alongside food and energy.
There is another piece of evidence, from the Office for National Statistics. In new research, it has produced data for what it calls “that part of inflation which is common to all goods and services in the index”. It can thus be considered, says the ONS, “the general underlying trend or core inflation rate across the whole economy”. It has calculated this trend or core inflation rate from January 2002 until last month — so a period of more than 20 years — and the average over that period is 2.75 per cent, which is closer to 3 per cent than 2 per cent.
Shifting to a 3 per cent inflation target would have costs. For the government, it would imply a higher debt interest bill and increased costs in the long term for uprating state pensions and benefits.
For everybody else, it would mean a higher price level. Under a 2 per cent inflation target, if achieved, prices rise by 22 per cent over ten years; with 3 per cent, it would be nearly 35 per cent. The 2 per cent target was chosen because it was a rate that did not interfere with business and consumer decisions; firms and individuals would not always be trying to beat inflation. That might also be true at 3 per cent, but it might not.
Perhaps most difficult would be the adjustment to a higher target, which could not be achieved without a loss of credibility and could not be tried until inflation has subsided a lot more, probably to 2 per cent, at least for a while. In this respect, moving the goalposts would not help us out of the present difficulties. But it might make such difficulties less likely in future.
Governments Can't Blame Inflation on Energy and Putin Anymore
TAGS Money and Banks
At the end of February 2023, the price of oil (WTI and Brent), Henry Hub and ICE natural gas, aluminum, copper, steel, corn, wheat, and the Baltic Dry Index are below the February 2022 levels.
The Supply Chain Index and the global supply-demand balance, published by Morgan Stanley, have declined to September 2022 levels. However, the latest inflation readings are hugely concerning.
Considering the previously mentioned prices of commodities and freight, if price inflation were a “cost-push” phenomenon, it would have collapsed to 2 percent levels already. However, both headline and core inflation measures, from the Consumer Price Index (CPI) to Personal Consumer Expenditure Prices (PCE) show extremely elevated levels and rising core inflationary pressures.
We have mentioned numerous times that there is no such thing as “cost-push” price inflation. It is only more units of currency going toward relatively scarce goods and services.
The monetary aspect of inflation has been proven on the way up and in the commodity correction. The Federal Reserve’s rate hikes have deflated the price of commodities despite rising geopolitical tensions, supply challenges, and robust demand growth. Rate hikes make it more expensive to store, take long positions, and finance margin calls. Powell offset the entire supply-demand tightness impact on prices.
Governments cannot blame price inflation on Putin’s war or the so-called “supply chain disruptions” anymore. Printing money above demand is the only thing that makes prices rise in unison. If a price rises due to an exogenous reason but the quantity of currency remains equal, all other prices do not rise. A PCE index of 4.5 percent in January 2023 with all the main commodities below the January 2022 level shows how high inflationary pressures are.
Price inflation is accumulated, and the narrative is trying to convince us that bringing down inflation from 8 percent to 5 percent in 2024 will be a success. No. It will be a massive destruction of more than 20 percent of purchasing power of citizens from inflation in the period.
However, rate hikes are not enough. Broad-based money growth needs to come down rapidly. So far, in the United States, broad money growth is flat and has declined to more reasonable levels in December 2022. However, the latest European Central Bank reading of broad money growth in the euro area points to a 4.1 percent increase, which is very high compared to modest gross domestic product (GDP) growth and certainly very high compared with the estimates for 2023.
Broad money growth was too aggressive in 2022 and it may take some time to ease the inflationary pressures to a level that does not make citizens even poorer.
Two recent papers published by the Bank of International Settlements remind us that money growth was the main culprit for the price inflation surge. Claudio Borio, Boris Hoffmann, and Egon Zakrajšek conclude that
(Does money growth help explain the recent inflation surge?). Reis explains that “Inflation rose because central banks allowed it to rise. Rather than highlighting isolated mistakes in judgment, this paper points instead to underlying forces that created a tolerance for inflation that persisted even after the deviation from target became large” (The burst of high inflation in 2021–22: how and why did we get here?)
The supply chain and Ukraine war excuse has vanished, but inflation remains too high. Many market participants want rate cuts and money supply growth to see higher markets, with multiple and valuation expansion. However, rate cuts are very unlikely in this scenario and central banks know they have caused a problem that will take more time than expected to correct.
Governments cannot expect price inflation to correct when public spending is rising, which means higher consumption of new monetary units via deficit and debt.
Citizens are suffering these inflationary pressures via weakening real wage growth added to much higher cost of living as the prices of nonreplaceable goods and services—education, healthcare, rents, and essential purchases—are rising much faster than the headline CPI suggests.
We are all poorer, even if headline price inflation is slightly lower. Slowing inflation growth does not mean lower prices, just a slower pace of destruction of the purchasing power of currencies.
Someone will invent another excuse to blame price inflation on anything except the only thing that causes prices to rise at the same time: printing currency well above demand.
Daniel Lacalle