Listen to U.S. Federal Reserve Chair Janet Yellen or Bank of England Governor Mark Carney these days and you might conclude central bankers are rethinking their inflation targets. Not quite.
Take Yellen. Having mused on Friday that a “high-pressure economy” might help heal the harm done by the recession, bond yields rose as investors bet that rising inflation may be less important to the Fed than boosting the labor market.
Or Carney, who in the aftermath of the post-Brexit slump in the pound is now saying he’s ready to “look through” faster price gains. U.K. inflation surged to the fastest pace in almost two years in September.
Yet having struggled for much of the last decade to push inflation higher, central bankers are still faced with a problem. Lower productivity growth and aging populations are depressing the neutral rate of interest, or the rate that neither spurs nor slows growth. That means less scope to cut borrowing costs in the next recession.
Some officials, mindful that interest rates are still near zero in a number of advanced economies if not actually negative, have asked if central banks ought to raise inflation targets to create more of a buffer against this zero boundary.
San Francisco Fed President John Williams has thought out loud about shifting the target, though there is no consensus inside the Fed for such a move. Fed Vice Chairman Stanley Fischer rejected the idea on Monday, noting that raising the target when you haven’t hit it in several years would only further undermine credibility. However, Fischer did sound open to considering periodic reviews of the target with lawmakers, as the Bank of Canada now does.
“You could argue that two or three years of overshooting following so many years of undershooting can help to stabilize inflation expectations, or that if you knew that the neutral rate was so low you’d start with a higher inflation target” said Nick Kounis, head of macro research at ABN Amro Bank NV in Amsterdam. “But there’s very little sign of regime change. Central bankers are in no way seriously considering options” to change their monetary frameworks, he said.
For the Fed, which has been under its 2 percent inflation target for four years, the risks of stoking price pressures by driving down the jobless rate look low. Its preferred gauge of inflation rose 1 percent in the 12 months through August, the same margin by which the BOE is missing its own 2 percent inflation goal.
While investors are expecting higher inflation, there’s little sign they’re alarmed. The five-year break-even rate, a gauge of price-growth expectations based on the difference between yields on five-year notes and similar-maturity Treasury Inflation Protected Securities, has climbed since the start of September to 1.58 percent, near its highest levels since May.
Price gains that suddenly reappear after years of absence have the potential to wrong-foot central bankers heavily invested in stimulus programs and low interest-rate regimes that are tricky to get out of.
Easy Policy
The Fed raised rates in December after seven years near zero, the European Central Bank has been running a negative deposit rate for two years and the Bank of Japan’s policy rate is also below zero. The BOE cut rates for the first time in seven years in August, and some economists foresee another move this year.
For central banks presiding over sluggish recoveries, removing policy stimulus before inflation speeds up may risk price pressures failing to reach the target. Keeping stimulus in place could see inflation overshoot. Adopting a higher inflation target during such a period may be hard to explain to the public.
“Changing the inflation targets themselves can be problematic from a credibility point of view,” said Jan von Gerich, global fixed income strategist at Nordea Bank in Helsinki. “Building credibility around a new target would be challenging and most likely more difficult than building credibility around existing targets. It appears to be a less risky strategy to try to stimulate the economies by allowing inflation to temporarily overshoot the inflation targets.”
Fed officials don’t forecast overshooting their 2 percent inflation goal and expect to reach it in 2018, according to their September projections. They see unemployment averaging 4.5 percent in the fourth quarter of that year, versus their full-employment estimate of 4.8 percent. In effect, they see a modest undershoot of their inflation target as compatible in the short-term with stable prices.
Exceeding the inflation goal, even temporarily, is a problem that some central bankers may wish they had. In Japan, where inflation is currently stuck well below the target, the credibility of BOJ Governor Haruhiko Kuroda’s pledge to push price gains beyond 2 percent before bringing them back again has stretched belief.
Europe’s Challenges
In Europe, while a few officials such as Bank of Italy Governor Ignazio Visco have mooted the idea of allowing overshooting, the 19-nation euro area isn’t forecast by the ECB to reach its just-under 2 percent target for at least another two years. That puts claims by German politicians -- that the ECB should begin to raise rates now -- into context.
Britain is struggling with stagflationary forces of a slumping pound and potentially weaker growth after its vote to leave the European Union. That means choosing between its inflation target or higher growth, and the Bank of England is opting for the latter.
Regular pay growth adjusted for inflation was just 1.7 percent in August, the least since February 2015, data released Wednesday showed. With some economists predicting inflation could average as much as 3 percent in 2017, well above the BOE’s 2 percent target, the pressure on household incomes is set to intensify.
“Central bankers are frustrated with the weakness of the economy in the U.S., in the euro area, in Japan,” said Torsten Slok, chief international economist at Deutsche Bank AG in New York. “I’m not sure that in the real world, with real markets, raising the inflation target is a good idea.”
(Updates with economist comment in 13th paragraph.)
--With assistance from Boris Korby Craig Torres and Jeanna Smialek To contact the reporter on this story: Jeff Black in Frankfurt at jblack25@bloomberg.net. To contact the editors responsible for this story: Paul Gordon at pgordon6@bloomberg.net, Alister Bull, Brendan Murray
©2016 Bloomberg L.P.
