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What does the current surge in inflation suggest about the longer-term inflation outlook? My focus here is on the UK. But the broad lesson may apply elsewhere: It is unreasonable to believe that central banks will achieve their long-term goals. More precisely, inflation will be asymmetric, with upward overshoots greater than downward overshoots.
Nearly two decades ago, I had a discussion with one of the Bank of England’s most senior officials at the time, in which it was suggested that although the bank rarely hit its 2% target precisely, the error should be symmetrical over time. of. The expected long-term outcome should be the price level implied by the 2% annual target. For many policymakers, expectations about future price levels are as important as annual inflation because it will determine the real value of sterling-denominated contracts (traditional bonds or annuities). If proven correct, inflation targeting would bring short-term policy flexibility and long-term price level predictability. This seems like an excellent combination and a rationale for inflation targeting.
The recent surge in inflation forces us to ask whether this is true. It seems not.
Let’s start in 2003, when the UK target was linked to the Consumer Price Index. Since then, despite the prolonged deflationary shock caused by the 2007-09 financial crisis and its aftermath, real price levels have been few and far between and only slightly below what a cumulative inflation rate of 2% would suggest. But the deviation is small. In February 2021, price levels were only 2% above what would be implied by continued success in meeting the target. The inflation target appears to have achieved the desired stabilization of price levels.
Since then, the story has been very different. In June this year, the consumer price level was 17% higher than the target level. In the previous three years, price levels had risen by a cumulative 21%. The UK has suffered almost 10 years’ worth of 2% inflation in less than a third of the time! By August, inflation appeared to have grown at a compound rate of 2.8% since June 2003, rather than 2%.
Not long ago, many policymakers were concerned that cumulative targets were being missed. In the U.S, This led to a decision to offset past shortcomings in future policy. This was not an issue for the Bank of England at the time. But assume past mistakes matter. Even if the inflation rate is zero, it will take until mid-2031 for price levels to return to the level where the 2% inflation rate has been since June 2003.
Banks are not forced to do this. Even so, this huge overshoot carries some important lessons.
What it tells us about the economy is that price levels are unlikely to fall, but can easily soar, as they did recently and in the 1970s. The second lesson is that policymakers work much harder to avoid deflation than they do to avoid above-target inflation. This is not surprising: maintaining economic activity is more popular and easier to achieve than pushing up unemployment.
The state of the business cycle also affects economists’ thinking. There are good reasons to ask whether 2% is the optimal target. However, only a few believe this level should be lowered after the financial crisis. Recently, however, influential economists have argued for a higher target as inflation surges. Moreover, as Soumaya Keynes noted, some economists have also pointed out that tight monetary policy can cause long-term economic scars. This is certainly true. But it is to be expected that such arguments will be made when inflation is high.
My conclusion is that, in the long run, monetary policy will be asymmetric. In a recession, central banks will ease monetary policy quickly and sharply; during an inflationary boom, they will be reluctant to react so quickly. Over the longer term, average inflation is likely to be above target.
That’s why I support the view of Catherine Mann, former chief economist of the OECD and current member of the Monetary Policy Committee. As she said in a recent thought-provoking speech, “I would rather err on the side of over-tightening.” The duration of high inflation matters, not least because it increases the likelihood that one will conclude that 2% inflation is unlikely to be a long-term outcome. The British evidence strongly suggests otherwise. A reasonable person should not believe this to be true.
martin.wolf@ft.com
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