Central Banks Are Put To Test

Central bankers believe that by setting an inflation target, they establish credibility for themselves and help individuals and businesses plan in ways that will keep inflation under control. As the practice of inflation targeting extended from New Zealand in 1990 to Europe and to the United States and Japan in 2012 and 2013, the idea looked to be backed by swaths of empirical data.

  • Central bankers are now facing the first direct test of how well that monetary policy strategy works once prices have exploded, and how tightly they'll enforce it if harm to their economy worsens
  • They attribute decades of stable prices to the implementation of a 2% inflation target and up until the end of 2020, inflation was generally under control
  • However, this also occurred at a time when demographic, technological, and globalisation trends were favorable

However, current trends may not be as favourable as many companies seek to decouple from China, Europe has given up on Russian gas and supply shocks continue to batter the world economy.

Some Sort Of Confidence

After the high inflation of the 1970s and 1980s, policymakers realized the need to establish their own credibility in the battle against inflation. They considered sticking to a proclaimed inflation target as an easy way to do both: set public expectations and develop confidence.

  • There is a general agreement that mild price increases are good for an economy, even though some inflation hawks still insist that the ideal level would be zero
  • It allows businesses to adjust "actual" labor costs without having to reduce hiring, and it gives central banks more leeway to handle economic downturns through interest rate decreases as opposed to bond purchases and other unconventional measures once policy rates reach zero or close to zero
  • Still, the 2% figure is not particularly significant in itself and although it is now the norm around the world, it was more of a best guess about an inflation rate that would capture the advantages central banks see in setting some sort of target - all while remaining low enough that the public wouldn't notice

Despite making significant adjustments over time to its "Statement on Long-Run Goals and Monetary Policy Strategy" the U.S. central bank has never looked back on that inflation target on the grounds that a promise is a promise.

Disclaimer

Please note that this article does not constitute investment advice in any form. This article is not a research report and is not intended to serve as the basis for any investment decision. All investments involve risk and the past performance of a security or financial product does not guarantee future returns. Investors have to conduct their own research before conducting any transaction. There is always the risk of losing parts or all of your money when you invest in securities or other financial products. Please note that the writer of this article is not registered as a financial advisor.

Credits

Photo by Robert Bye on Unsplash.