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Should central banks desecrate the hallowed 2% inflation target?

Date: March 23, 2023 Time: 01:20:51

Is it real to maintain a 2% inflation target in the markets taking into account the structural problems of supply and demand? This is a debate that is increasingly flourishing in the current economic environment: investors are beginning to wonder if central banks are likely to raise their inflation targets.

Since the introduction of these targets in the 1990s, advanced economies have united around a common 2% target. In the intervening decades, central banks have largely succeeded in keeping inflation low and stable. But in recent years this has been blown away, as it has skyrocketed to the highest level in a generation, igniting debate over whether policymakers should ditch the ubiquitous 2% target and instead set your sights on higher prices.

Those who support an inflation target of 3% or even 4% argue that this would imply higher nominal rates. Higher nominal rates would reduce the risk of central banks being constrained by the Effective Lower Bound, or “ELB”, as they would have more room to reduce borrowing costs when faced with a economic recession. “It’s a seemingly simple solution to the problem that has plagued policymakers in the years since the global financial crisis,” George Brown, an economist at Schroders, said in a report.

Although it comes with its own challenges. One of them is whether inflation could converge towards the upper target. It’s a challenge the Bank of Japan knows all too well. 10 years ago, it raised its inflation target from 1% to 2% in an attempt to overcome chronic deflation. And, to encourage inflation, it launched a colossal quantitative easing that has seen its balance rise from 30% to 130% of GDP. Needless to say, it doesn’t work. Barring a tax hike in 2014, inflation remained stubbornly low, at least until the recent global upswing.

“Although the Japanese economy is somewhat unique, other countries struggled with persistently low inflation over the same period,” Brown said. “One of the factors was the financial crisis, which opened up an output gap in the G7 of 5.8% of GDP that took several years to narrow,” he adds.

In this sense, another factor would have been globalization, especially after China’s accession to the World Trade Organization in 2001. brown.

The end of inflation moderation

Some experts say that some of these disinflationary trends might be expected to reverse. “We may be in a regime shift towards a less globalized world, in which security and proximity are prioritized over efficiency and cost considerations that have characterized the globalized model of long supply chains in recent decades,” highlighted.

This change could lead to further stagflation that pushes up inflation and slows global growth. One driver of this change could be “fiscal activism,” which could lead to central banks raising inflation targets, or removing their independence. It seems likely that governments will become more fiscally generous after voter expectations have changed due to pandemic support plans. Fiscal activism could be another potential source of upward pressure on inflation in the short and medium term.

Pathways to more active fiscal policy, Schroders says, could include governments modifying the central banking system to manage the impact of additional spending. “A scenario in which regulation is used to direct funds into the bond market, combined with changes in the mandate of central banks to tolerate higher inflation, is not inconceivable, should we see big changes in political priorities. as a result of populism, for example”, he says.

It would also be questionable whether higher inflation should be tolerated unless anemic productivity growth can be improved. Most empirical studies find a negative connection between the two, but move to a higher trigger regime that could help stimulate investment. “But if productivity remains low and other countries do not also raise their inflation targets, there will be a gradual erosion of competitiveness and a deterioration in living standards,” Brown argues.

The lack of credibility

Raising the inflation target also risks damaging the credibility of central banks. In particular, the Federal Reserve and the European Central Bank, whose recent policy reviews have shown a willingness to tolerate excess inflation after years below 2%. But, turning 180 degrees and raising their targets amid high inflation could give the impression that they are not in control and risk unanchoring inflation expectations beyond the new target.

This is a very delicate situation. Above all, because the bargaining power of workers is high and should remain so in the face of an aging population, anti-immigration sentiment and offshoring efforts. Therefore, companies would have no choice but to accede to the workers’ demands to be compensated for the increase in inflation.

“Unless productivity growth can keep up, it risks triggering a price-wage spiral that has to be stopped by central banks through aggressive, Volcker-style tightening,” Brown said. .

So, although it seems that inflation will be structurally higher in this decade than in the previous one, this is by no means guaranteed. And if so, supply-side reforms are likely to be needed to accommodate it, otherwise competitiveness and living standards may suffer. “In addition, central banks have to first achieve their current goals in a sustainable way to ensure their credibility. Until these criteria are met, it is premature to speak of abandoning the 2% inflation target,” says the British manager’s expert.

Puck Henry
Puck Henry
Puck Henry is an editor for ePrimefeed covering all types of news.

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