Central Bank Flexibility Sparks Market Volatility
2 August 2023
Private: Baby Blue Test
11 August 2023INSIGHT • 9 AUGUST 2023
“Two-Percentism” and Its Dangers
Kambiz Kazemi, Chief Investment Officer
"This (i.e. 2% inflation) is going to be the target, so adjust your plans to that, or the social and economic costs will be considerable."
Don Brash, Governor of the Reserve Bank of New Zealand, 1989
While inflation readings in most developed countries have dropped noticeably in the last year – US Consumer Price Index YoY is down to 3% from a high of 9.1% in July 2022 – central banks continue to beat the drums of hawkishness, declaring that the fight against inflation is not over yet. In all fairness, uncertainty around secondary effects due to a potential rise in wages or the effects of the recent increase in energy prices lies ahead of us.
However, as central banks continue their sacrosanct pursuit of the two percent inflation target ( “Two-Percentism”) we are likely contemplating higher rates for longer. While some economies might be able to handle the effects of higher rates for longer, others, in our view – in particular, Canada – could suffer corollary effects whose cost might far exceed that of inflation running marginally above the two percent target, say, 3 or 4%.
As we wrote in Beware of Common Wisdom, this 2% target is “a self-defined benchmark barely a few decades old. This approach followed the inflation trauma of the 1970s and results from regulators’ holistic and qualitative thoughts”. More recently, prominent voices such as former World Bank Chief Economist Olivier Blanchard or Dr. El-Erian have stated that there is nothing scientific about the 2% target rate and that it might be appropriate to review it and/or have some flexibility around it.
The emergence of Two-Percentism
It all started in 1988 with an ad hoc remark on TV from New Zealand’s Finance Minister at the time, who said he wanted to see inflation between 0 and 1% (inflation was running at 10% at the time). The Reserve Bank of New Zealand settled on a target inflation rate of 2% by rounding up their estimated upward bias of 0.75% plus the 1% (unbiased target)!
Canada promptly followed in 1991, the UK in 1992, and Australia in 1993. The US Federal Reserve, which has a dual mandate of price stability and employment had an implicit inflation target of the same order, leaving it some flexibility. In 2012, it formally adopted Two-Percentism under the guidance of then Vice-Chair, Janet Yellen.
Suffice it to say that not only was there no “science” or in-depth empirical work behind the advent and widespread adoption of the 2% target in the 1990s, but the empirical studies gauging its effectiveness, effects, and appropriateness mainly came out in the early 2000s.
Beware of Pseudo-Measures
Central banks have relied on target inflation levels as the near sole driver of monetary policy and determinant of interest rates. One could argue that no single economic measure has affected the lives of all, the world economy and by association the path of contemporary world history, more than inflation.
That is why inflation, both as a concept and a measure, must be understood and handled cautiously. In particular because:
A. Inflation is not a universal measure
The field of economics has generally tried to emulate a scientific approach—which consists of building models based on hypotheses—to try and explain “real world” economic phenomena.
Inflation is often presented and/or perceived in economics as a universal measure at the heart of many economic models (such as the Phillips Curve) in the same way mass, length, or speed measurements are inputs into physics equations.
However, no two measures of inflation are the same. 3% inflation in the EU is not the same as 3% inflation in the UK or US. Why? Because the way inflation is calculated can – and does – differ in each country. Both the inputs and the calculation methodology are different in each jurisdiction. As a result, inflation is not an absolute measure like length or speed.
So, by using the EU methodology with US or UK inputs, one could obtain different values for inflation. Yet, everyone targets 2% inflation!
One could argue that being insistent about conducting a monetary policy with a surgically precise 2% target is akin to trying to measure length with a ruler which has lines whose distances change depending on which country one takes it to. It is not possible to establish a proper result with such a ruler, and no monetary policy should be conducted based on a dogmatic approach to an imprecise measure.
B. Inflation is not a time-consistent measure
One meter was represented by the same length 100 years ago, 20 years ago, and today. But inflation is not time-consistent: its methodology has changed many times, as have its inputs and the way they are gathered (e.g., some goods or services we purchase today did not exist 15 years ago).
How can we have a universal policy rule (i.e., inflation targeting) when the target moves through time? 2% inflation in the 1990s is not the same as 2% in 2023, despite efforts to make them “comparable,” and yet policymakers try and target the same level.
Conclusion
Unfortunately, economics cannot exist as it is often taught; it is not an exact science ruled by aesthetic mathematical equations and universal coefficients. The reality of economics is that of complex systems where individual and group behaviors are intertwined. Where both are affected by and affect monetary and fiscal policy. To understand and manage such systems, flexibility and adaptability are crucial, and an overreliance on models, forecasts, and natural (perceived) relationships and “laws” can lead to undesirable outcomes and/or crises. It is quite ironic indeed that the failure of forecast models caused the delay in central banks' response to the inflationary forces post-Covid. Similarly, we see an overzealous observance of Two-Percentism as an important risk to developed economies in the quarters to come.
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