Should central banks reconsider their inflation target?

Should central banks reconsider their inflation target?
Should central banks reconsider their inflation target?

In 2012, former chairman of the US Federal Reserve (Fed) Ben Bernanke strongly stated that the central bank would conduct monetary policy with the goal of keeping inflation at two percent. The head of one of the most important central banks at the time called it an important goal.

However, the American Fed is not the only central bank in the developed world that is trying to fulfill this very goal in the long term. For example, the European Central Bank (ECB), the central bank of Canada, Japan, and the Czech National Bank (ČNB) also have the same.

In fact, the Bank of England is so committed to its two percent target that if inflation deviates by more than one percentage point in any direction from the target, the governor must explain the reasons and propose a fix in an open letter to the government.

But why do most central banks agree on a two percent value? Where did this number even come from? The springs go to New Zealand.

The beginnings of targeting

When Don Brash became governor of New Zealand’s central bank in September 1988, his country was slowly recovering from a period of high inflation that had exceeded 15 percent only about a year earlier. At the time, central banks around the world were trying to ensure stable prices, using various measures to do so – for example, exchange rates or the growth rate of the money supply.

“The Labor government at the time was trying very hard to deal with inflation. It ordered the central bank to reduce inflation without specifying specifically what the reduction meant,” Brash recalled for the Quartz business portal.

A few months before Brash took office, New Zealand Finance Minister Roger Douglas appeared on television to discuss the government’s approach to monetary policy. This included specific inflation targeting, i.e. a method that has appeared in the economic literature for years, but has not yet been implemented anywhere.

At the time of Douglas’s TV appearance, the inflation rate fell below ten percent for the first time in several years. Brash further recalls that the interviewer asked the then finance minister if the government was now satisfied with this lower level of inflation. At the time, Douglas replied, “No,” Quartz reports.

When New Zealand’s parliament decided on a two percent inflation target for the country’s central bank in December 1989, none of the lawmakers were against it…perhaps because they were about to go home for the Christmas holidays, reports The Economist weekly. Anyway, over time, the two percent inflation target became the standard of most central banks, including the CNB.

Two percent target

Why two percent, you might ask. According to economists, countries have come to terms with the fact that high inflation slows economic growth, so central bankers prefer a low, stable number.

At the same time, two percent did not seem like too low a value to them. This would be undesirable because it would push interest rates down so much that, in the event of a recession, central banks would no longer be able to cut rates further to support a collapsing economy.

CNB’s goal

  • Since 2010, the inflation target of the CNB has taken the form of a year-on-year increase in the consumer price index of two percent. The target at this level corresponds to the practice of central banks of advanced economies.
  • The CNB regularly evaluates the fulfillment of the inflation target, based on statistical data published by the Czech Statistical Office, i.e. an institution independent of the central bank. This arrangement increases the credibility of inflation targeting.

Central banks strive for price stability (that is, a situation in which prices are maintained at a certain level considered reasonable for a certain period of time), which would technically correspond to zero percent inflation. There are several reasons why, when striving for stability instead of real stability, i.e. targeting zero inflation, they usually aim for two percent, as Vít Hradil, chief economist of Cyrrus, explains for SZ Byznys.

“Since monetary policy is not perfectly precise, any target is at risk of its minutes. In the case of targeting zero percent, even with relatively small inaccuracies, there would be a risk of negative inflation – i.e. deflation, which is generally considered a risky phenomenon. The target at the level of two percent thus gives the central bank some room,” Hradil states as one of the reasons.

Tolerance band

  • Although the CNB strives for inflation to be at two percent, actual inflation deviates from the inflation target, primarily as a result of unpredictable shocks that continuously affect the economy.
  • Although the central bank reacts to the consequences of these shocks, it is neither possible nor macroeconomically meaningful for it to return inflation to the target immediately. The natural volatility of inflation is captured by a tolerance band with a width of one percentage point in both directions around the inflation target.

Jiří Polanský, an analyst at Česká spořitelna, adds to this that an inflation target of around two percent is generally considered to be price stability, which is also influenced by the way in which consumer inflation is calculated – it overestimates actual inflation by roughly 1 to 2 percentage points.

According to Polanský, on the one hand, the Consumer Price Index (CPI) may not fully take into account the increasing quality of goods and services, including public ones, and on the other hand, it does not take into account the substitutions that households make during purchases.

“If, for example, households buy two kinds of lemonade and one of them gets a significant discount, households will start buying the discounted one much more compared to the one that remained more expensive. However, the construction of CPI inflation assumes that households still buy both sodas in a constant proportion, thus overestimating actual inflation. The influence of this effect increases significantly at the present time, when prices are rising rapidly and households are more often looking for the cheapest alternatives,” explains Polanský.

Change of destination?

Should central banks reconsider their inflation target given how high inflation is now? Former CNB vice-governor and current MEP for TOP 09 Luděk Niedermayer does not think so.

“I doubt that it is reasonable to open this discussion, especially in a situation where the central bank misses the target. In addition, given that inflation is predicted by very complex models that work with the credibility of the declared target, I do not think that this would bring about a fundamental change in monetary policy.”

“From the point of view of the CNB, from a small, open economy with a floating exchange rate, it would perhaps be unpleasant if we were to target inflation other than our reference area, which is the eurozone. A higher target would evoke higher interest rates, and the interest differential would then lead to capital movements that would affect the exchange rate. Which would be a more complex environment for the central bank to work in. That’s why I think it’s crucial for us what the goal of the European Central Bank is,” says Niedermayer.

According to Polanský from Česká spořitelna, although the inflation target can be changed simply by announcing a change in the target inflation, it should remain the same in the conditions of the Czech economy.

“His change would essentially be a resignation to price stability. Moreover, it is not necessary. The Czech economy is closely linked to the eurozone, whose price development influences the Czech one in the long term, and it can thus be assumed that after the current inflationary shock subsides and assuming at least a somewhat responsible fiscal policy, inflation in the Czech Republic will return to close to the price development in the eurozone,” he describes analyst.

According to economist Hradil from Cyrrus, the discussion about alternative monetary policy goals is quite lively in professional circles, but it has not yet produced convincing evidence that any other monetary policy regime would be better than the current one.

“At the same time, monetary policy relies significantly on consistency and predictability. This means that the very public awareness of what its central bank is trying to achieve and how helps to stabilize the economic environment. For example, in our country, the public has experienced that inflation should be close to two percent,” explains the economist.

According to Hradil, any attempt to change the monetary policy regime carries with it the risk that the transition to it will be complicated precisely because the public will not perceive or understand it carefully enough.

“In that case, its behavior will be in conflict with the new goal, and the central bank will have to enforce its policy ‘by force,’ which entails greater social costs,” adds Hradil.

Ideal inflation

“However valid the argument is that some of our prices are still lower than prices in the eurozone, a situation where we would like to have systematically higher inflation than the eurozone brings considerable problems,” thinks Niedermayer, a former member of the CNB banking board.

“The volatility of the koruna exchange rate, especially the strengthening caused by higher interest rates, also entails changes in inflation through imported inflation or deflation. Therefore, I think that striving for our inflation to be slightly higher than in the eurozone is not an attractive strategy,” Niedermayer describes.

According to him, the two percent goal makes the most sense, or the effort to keep inflation between 1 and 3 percent. At the same time, according to Niedermayer, the CNB should strive to bring today’s extremely high inflation back to these levels in the foreseeable future.

“A much more important factor than the goal itself is the extent to which it is actually achieved. In principle, there would not be much difference between a target at the level of 1, 2, or 3 percent, provided that it is credible and expected. Pricing throughout the economy will easily adjust to it. A much greater danger than a target slightly higher or lower than two percent is when the target cannot be achieved,” adds economist Hradil.

The article is in Czech

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