With underlying price pressures proving stubborn in the US and Europe, there is growing concern in some quarters that bringing inflation down to sustainably low levels will prove more difficult than hoped. Indeed, in last month’s commentary we highlighted trends that might suggest we are moving into an era of structurally higher inflation.
Against this backdrop, there is a good chance that calls for central banks to jettison their 2% inflation targets, either formally or informally, will grow louder in the months and years ahead. In this month’s commentary we examine the case for raising inflation targets, some potential problems, and possible implications for asset classes.
Too high a price?
There are several reasons why central banks in advanced economies might consider ditching their 2% inflation targets. One reason is that the costs involved in getting inflation down from its current elevated level to 2%, both in terms of lost economic output and increases in unemployment, might be deemed too high. One recent study which examined 16 past disinflation periods in the US, Germany, Canada and the United Kingdom found that there was no instance in which a significant central bank-induced disinflation occurred without a recession1.
Although favourable base effects should be supportive of a marked fall in inflation in the US and Europe this year (see our commentary of January 20232), getting inflation down to 2% and keeping it there without hobbling the economy could prove difficult. Inflation expectations on the part of businesses3 and consumers4 are elevated. And several factors (deglobalization, demographics, green transition) suggest we could be entering a period of structurally higher inflation (see our commentary of February 20235).
Unemployment is currently historically low in the US and Europe, but opposition to the maintenance of restrictive monetary policy is likely to grow as jobless totals rise. Faced with such pressure, central banks might eventually give up on trying to keep inflation at 2%.
Zero Lower Bound
On a more theoretical level, some economists argue that pursuing a higher inflation target during normal times could also make monetary policy more effective in stimulating the economy when recession hits. This idea relates to the difference between nominal interest rates and so-called real interest rates (i.e. the rate when adjusted for inflation), and the practical reality that policy interest rates cannot be pushed much below zero.
Central banks set policy rates in nominal terms, but the extent to which policy is loose or restrictive hinges on the real, inflation-adjusted, rate. By way of a simplistic example, monetary policy would be looser in an economy where the interest rate is 10% and inflation is 9% (i.e. real rate = 1%), than one where the policy rate is 5% and inflation is 1% (i.e. real rate = 4%).
Advocates for raising central banks’ inflation targets argue that if inflation was allowed to run hotter, say at 3% rather than 2%, this would mean that the central bank interest rate would be higher for any desired level of policy stance. For example, if a central bank wanted to set a real rate of 2% when inflation was 2%, it would set the policy rate at 4%. Under a scenario where inflation is running at 3%, a real rate of 2% would require a policy rate of 5%.
As a result, it is argued that a higher inflation target will make it easier for policymakers to avoid the so-called ‘zero lower bound’. Interest rates cannot be cut much below zero without causing problems for the banking sector; depositors might withdraw their money from banks if they had to pay the bank to hold their money. Consequently, a higher starting level of nominal interest rates and inflation would provide more scope to cut interest rates (and thereby reduce real rates and stimulate the economy) in the event of the economy entering a downturn. As a result, the risk of interest rates hitting the zero lower bound would be reduced.
It seems like a world away now, but it will be remembered that during the years following the great financial crisis (GFC), the problem policymakers faced was not inflation, but rather the risk of deflation (i.e. a fall in the general price level). With interest rates cut close to zero in the US and the UK, and slightly negative in the eurozone, policymakers had to resort to unconventional policy measures (such as quantitative easing, QE, or buying bonds) in order to provide more stimulus.
Under a higher inflation target regime, it would therefore be easier for policymakers to provide more conventional stimulus, and therefore limit the degree to which economies suffer during downturns. Some observers argue that if we had had a higher inflation target, the recession following the GFC would have been less severe.
A slippery slope
However, there are clear risks involved with raising the inflation target. One obvious danger is that an increase the inflation target will not be seen as one-off change, but rather a move down the slippery slope towards central bank tolerance of ever higher inflation. If central banks can raise the inflation target from 2% to 3%, they might increase the target from 3% to 5% in the future.
Central banks’ credibility in establishing low and stable inflation expectations around 2% has been hard won over the years and has been a key factor in actually achieving low inflation (for example, if workers expect inflation of 2%, they will adjust their wage demands accordingly and make the actual achievement of low inflation more likely).
Investors might conclude, with good reason, that a higher inflation target would also imply more volatile inflation and less predictability. As a result, they would demand a higher premium for investing in the bonds of such a country. In turn this could result in a disproportionate rise in borrowing costs in capital markets. Higher inflation would also risk creating more uncertainty and could make businesses wary of making long-term business decisions, a factor that could ultimately undermine a country’s long-term growth potential.
A move away from a 2% inflation target (the level currently adopted by most central banks in advanced economies) could be particularly costly if the decision was a unilateral one i.e. one adopted in isolation and not pursued by other central banks. The experience in the UK of the short-lived Truss administration - which proposed a non-conventional fiscal policy during the autumn of 2022 and unleashed heavy selling of UK Gilts and the pound6 - provides a salutary lesson of what can happen when policymakers go against the grain of conventional thinking and lose credibility.
Asset Class Implications
What might a move towards a higher inflation target mean for different asset classes?
As we alluded to earlier, an overt move to raise the inflation target is likely to result an increase in government bond yields, and therefore lower bond prices, as investors price in the prospect of higher and more volatile inflation. Moreover, as the risk of higher than expected inflation becomes greater over time, it might be expected that yields on longer-dated bonds will rise more than those on short-term debt, with the result that the so-called yield curve (see our commentary of April 20227) would steepen.
Higher inflation expectations are likely to be reflected in an increase in the so-called breakeven inflation rate (the difference between the nominal yield on a fixed-rate bond and the real yield on an inflation-linked bond). As a consequence, the move to a higher inflation target would probably see nominal bonds underperform their inflation-linked counterparts with the same maturity and credit quality.
Raising the inflation target might, under certain circumstances, bring better news for equity markets. The performance of equities in part depends on the outlook for corporate profits, which in turn is partly dependent on economic growth. If a higher inflation target gives central banks greater scope to provide monetary stimulus during recessions, this might result in less severe downturns than otherwise would have been the case.
In turn, the potential for higher nominal GDP growth – resulting from higher inflation and more modest contractions in real GDP during recessions – over the course of the business cycle could be supportive of corporate sales and profits growth. Businesses with strong pricing power and an ability to pass on rising costs to protect margins are likely to disproportionately benefit. In terms of sectors, banks could profit from an expected steepening in the yield curve, which should be supportive of net interest margins.
Real assets, such as commercial property and commodities might be expected to do well under a regime of higher inflation targets. Income from commercial property could benefit from a higher inflation environment, especially where rents are index-linked.
This said, while income streams from commercial property rents and corporate profits could be boosted by a higher inflation environment, there is risk that an ‘unanchoring’ of inflation expectations could usher in an aggressive interest rate response from central banks. If central banks feel the need to raise interest rates sharply to restore credibility, then real bond yields would rise, and this would weigh on property and equity valuations, as was the case in 20228.
A fudge?
Given the potential risks of a formal increase in inflation targets, it is not surprising that central bankers, such as US Fed Chair Jerome Powell, have rejected the idea9. Indeed, with the Fed having already tweaked its inflation target and shifted to a flexible average inflation targeting regime back in 2020 (see our commentary of September 202010), another change so soon would undermine the Fed’s already tarnished reputation.
Even if a formal change in inflation target seems unlikely, a tacit shift might still be forthcoming. Central bankers might decide that once inflation has fallen back to 3% or so, the extra economic pain required to get to 2% is not worth it, and start easing back on the policy front. Such an outcome could become increasingly likely if, for reasons of financial instability (for example, the fallout following the recent collapse of Silicon Valley Bank11), central banks feel that they cannot keep monetary policy as tight as needed to bring inflation back down to 2% on a sustained basis. The outlook remains highly uncertain, but investors would be wise to prepare for the possibility of an overshoot of current 2% inflation targets during the years to come.
14th March 2023
1 https://www.reuters.com/business/retail-consumer/fed-needs-recession-win-inflation-fight-study-shows-2023-02-24/
2 https://www.afhwm.co.uk/resources/commentaries/economic-commentary-what-is-the-outlook-for-the-global-economy-in-2023
3 https://www.bankofengland.co.uk/decision-maker-panel/2022/september-2022
4 https://tradingeconomics.com/united-kingdom/inflation-expectations
5 https://www.afhwm.co.uk/resources/commentaries/economic-commentary-are-we-transitioning-to-an-era-of-structurally-higher-inflation
6 https://www.morningstar.co.uk/uk/news/226770/gilt-yields-spike-pound-slides-on-mini-budget-tax-cuts.aspx
7 https://www.afhwm.co.uk/resources/commentaries/economic-commentary-what-is-the-yield-curve-and-why-is-it-making-some-investors-nervous
8 https://twitter.com/ISABELNET_SA/status/1613496073862914049
9 https://www.reuters.com/markets/us/feds-powell-again-rejects-idea-raising-inflation-target-2023-03-07/
10 https://www.afhwm.co.uk/resources/commentaries/monthly-economic-commentary-september-2020
11 https://www.reuters.com/business/finance/banks-break-markets-hear-sound-peaking-rates-2023-03-13/