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Rethinking Central Banks’ 2% Inflation Target

January 24, 2024

With a new rate regime underway, Fred Demers, Director, Multi-Asset Solutions Team, digs into one of the core assumptions of all fixed income allocations—the 2% inflation target – while providing valuable historical context on it.

When paradigms shift, unquestioned truths from a previous era often come undone. One such example can be found in the fixed income universe, where interest rates recently rose from near zero percent—a historical low at which they hovered for more than a decade—to above 5% in a relatively short span. During this upheaval, a core assumption of monetary policy appeared to be under threat: the 2% inflation target.

Prevailing wisdom says the 2% threshold provides an optimal trade-off between price stability and economic growth. However, the past couple of years have shown that a remarkable surge in inflation, followed by an aggressive series of central bank rate hikes, can be compatible with positive economic growth. Having experienced two years of runaway inflation and nearly full employment, does the central banks’ model continue to make sense?     

Origins of the 2% Inflation Target

Starting in the late 1970s, economic literature began to focus on the problem of anchoring inflation expectations. The post-WWII experience was of an excessively violent business cycle, and what made matters worse was that monetary policy had not evolved. Central banks were still relying on old fashioned monetary policy techniques to steer the economy. They added to or removed from the money supply at will, creating awkward incentives for commercial banks, which then learned to adapt into faster, wiser, and more cunning lenders of capital.  

Greater financial innovations led to a higher velocity of money within the economy, which meant that cash, which used to be unproductive and lazy, could no longer sit still. It was suddenly being turned over faster and more frequently. The economy heated up. Inflation rose to double-digit levels by 1981,1 which fostered uncertainty, and central bankers had no choice but to take stock of what their interventions had unwittingly caused. Unstable prices had massive implications for the ability of companies to make long-term investment decisions. As a result of those experiences, it became widely understood that macroeconomic volatility was closely tied to inflation uncertainty. We learned that the business cycle was ultimately driven by the inflationary cycle, which itself was a symptom of excess demand or supply in the economy.

Personal Consumption Expenditures, Excluding Food and Energy (Chain-Type Price Index): January 1960–November 2023

A line graph showing personal consumption expenditures since January 1960.

Some policymakers saw this as an opportunity. Led by U.S. Federal Reserve (the “Fed”) Chairman Paul Volcker, central bankers began to use interest rates—or rather, the cost of money—as a more powerful tool to control the business cycle. While this idea may seem banal and commonplace today, it was considered a radical “experiment” when the Fed aggressively pursued disinflation four decades ago. It worked and prices began to cool from Volcker’s relentless rate hikes, effectively proving that inflation could be contained through monetary policy. The next natural question was: if you are containing inflation, why not have a target?

The Reserve Bank of New Zealand was the first to implement an official inflation target in 1990, citing a preferred range of 0% to 2%. But this number was considered arbitrary and overly ambitious at the time as inflation in New Zealand had been running above 7.6% and had averaged more than 10% annually for two decades.2 Nonetheless, some central banks were quick to follow, beginning with the Bank of Canada in 1991 and the Bank of England in 1992. The Fed, by contrast, only adopted the system in 2012 after its then-Chairman Ben Bernanke introduced a dual mandate of price stability and full employment.

Inflation: A Moving Target

Importantly, inflation targets are not carved in stone. Despite its initial experiment being incredibly successful, New Zealand shifted its target on two separate occasions: first to 0% to 3% and then later to 1% to 3%.2 In August 2020, the Fed moved to a “flexible” inflation targeting model that seeks to average 2% inflation over time rather than adhering to the firm principle on a yearly basis.3 The purpose, they said, was to continue to anchor inflation expectations while enhancing their ability to promote maximum employment during times of economic distress. Is there an ideal inflation threshold? Is 2% better than 3%? According to the literature, most writings in favour of 2% appear to have been issued by central banks. Academics are less likely to claim a side, given that the optimal trade-off between inflation and economic growth is a question that remains unsettled. Context remains part of the issue. When Bernanke was steering the Fed, for example, his main objective was to avoid a Japanese-style deflationary spiral, which at the time was perceived as a greater and more material risk than hyperinflation.

Central banks prefer to keep the game simple—the higher the target range, the less likely they will run out of room to cut interest rates.

Ultimately, it would not be a major surprise if the Fed considered moving its target to 3% in order to permanently anchor inflation expectations higher. Both U.S. labour markets and GDP growth have demonstrated an impressive amount of resilience in the wake of pandemic-driven inflation, and in general, higher inflation targets tend to keep policymakers in the realm of traditional monetary theory. Central banks prefer to keep the game simple—the higher the target range, the less likely they will run out of room to cut interest rates and need to rely on unconventional tools, such as negative rates and quantitative easing.  

The Expected Market Response

In our estimation, the market would—or perhaps should—interpret an upward revision to the inflation target as a positive signal. The move would indicate that the economy does not require the same degree of tightness, all else being equal, and demonstrate the Fed’s willingness to allow the economy to run hotter. It would also paint their earlier move toward average inflation targeting as a first step away from the zero lower bound.  

It is worth remembering that all central banks desire a positively-sloped yield curve. It is viewed as measure of economic normalcy, yet the 2% limit means policymakers often have to put handcuffs on growth precisely when animal spirits are starting to take hold. This deliberate inversion of risk can be surprisingly damaging—it forces investors to sit in cash when they should be rewarded for taking on duration. It drives capital to become unproductive and lazy, and puts sand in the economic gears. What we should want instead is for capital to be chasing growth, taking measured chances, and financing the future. 

One hesitation policymakers may have is that by shifting the target, they risk de-anchoring inflation expectations entirely. For example, the market could witness a move to 3% and immediately begin speculating about an increase to 4%. Losing control of the narrative in this manner poses significant risks for the Fed. Communication exercises are an essential part of the central banker’s toolkit, which is why the Fed will likely initiate a research agenda at the outset to explore potential consequences if it does pursue this shift.

Unlike their peers at the Fed, officials at the Bank of Canada are unlikely to pursue a change to their current inflation targeting. As covered by my colleague Brittany Baumann in Diverging Paths: Behind the U.S. and Canada’s Economic Schism, a recent split in the U.S. and Canadian economies reveals sharply different underlying strengths and weaknesses. Canada’s interest rate sensitivity, for instance, suggests its labour and housing markets are simply unable to withstand continual rate hikes as well as their American counterparts.

Whether or not inflation targets are altered, the fact remains that the next decade of interest rates is unlikely to mirror the one that preceded it. Institutional allocations have already changed accordingly during the past 12 to 18 months—cash offered a safe haven during the tightening; however, we appear to have reached the peak of the monetary cycle and risk-free assets do not offer optimal exposure to future rate cuts. A new dynamic is taking shape—one where institutional investors have a long runway for a full cycle to unfold.

Please contact your BMO Institutional Sales Partner to learn more.

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