Rather than a week, as in politics, a decade can be a long time in central banking. At least that was the case before Covid-19.
Amid all the headlines about the acceleration of inflation and whether central banks risk being left behind the curve, it’s interesting to note that it wasn’t that long ago that they had a different concern.
About a decade ago, in the wake of the global financial crisis, followed by the debt blowout that almost saw Greece leave the monetary area, the question was whether the European Central Bank (ECB) would ever get inflation up to its then goal of “close to, but below 2%”. After years of negative interest rates and trillions in asset purchases, it seemed to go nowhere.
The minutes of its September meeting show it now has a different worry, with members of its governing council concerned it has underestimated the surge in inflation, blamed on supply constraints as economies opened up in the wake of the Covid-19 lockdowns, and more recently an energy crunch that has hit economies and boosted prices from China to the UK.
Some of the more cautious policymakers argued that the central bank, which sets policy for 19 countries that share the euro, might be too optimistic in its inflation forecasting, which sees the rate settling at 1.5% in 2023, from an average 2.2% in 2021. It was 3% in August.
In July, the ECB changed its inflation goal to a point target of 2%, which implied a tolerance of a slightly higher rate. Eventually the prevailing view after its last meeting was that tightening policy now would be a mistake that could drive borrowing costs higher than necessary.
Those with longer memories will remember how then ECB president Jean-Claude Trichet hiked rates twice in 2011, just as the region was heading to a prolonged period of low and negative inflation, and no economic growth. When he took over as ECB head later that year, Mario Draghi reversed the hikes. His reign would be defined by his July 2012 pledge to do “whatever it takes” to save the euro, which included breaking taboos and fighting with the German Bundesbank, which opposed negative interest rates and quantitative easing.
From the US to SA and the UK, central bank leaders are being asked the same questions, and will probably be subject to the harsh judgment irrespective of what they do. If they do nothing they will be blamed for letting inflation run away and expectations to settle at higher levels, leading to potentially even more aggressive rate hikes later.
Already in economies such as Germany, where workers generally have had a reputation for being constrained in their wage demands, there is evidence that they are seeking settlements based on realised inflation rather than guidance from the central bank. With economists expecting euro-area inflation to hit 4%, this could become self-fulfilling and entrench the idea that the central bank is willing to tolerate higher levels of inflation.
They could try to nip this in the bud and seek to reinforce the credibility of their targets, but then they’ll also get a beating as they will be blamed for the resulting economic slowdown, at a time when economies are just emerging from the shock of Covid-19.
An interesting question that has raised its head in SA is whether the type of target adopted has an effect on the credibility of inflation targeting, and ultimately inflation expectations and outcomes. Reserve Bank governor Lesetja Kganyago argued for a point target for SA with a small degree of tolerance on either side, say one percentage point, to replace the current 3%-6% range.
In a speech at Stellenbosch University in September, he argued that SA would have had better inflation outcomes if it had a point target, rather than the range, which people came to see as aiming for 5.99%.
Interestingly, the head of the ECB’s monetary policy research division issued a paper a few months ago examining this point. Unfortunately, SA wasn’t among the case studies chosen by Michael Ehrmann and his team, who looked at 20 emerging and advanced economies. They examined whether it was the case that targets with range or intervals led to less anchoring of inflation. They largely found the opposite; that ranges enhance credibility because they are missed less often.
The findings were still not as conclusive as one would have wished either way, but they dismissed the so-called flexibility hypothesis almost out of hand, and said the evidence “generally finds that target ranges or (in cases) tolerance bands outperform the other types”.
Central banks tend to have three types of targets: a point target; having a tolerance band around that target; or adopting a range, as we have in SA. The first inflation-targeting country, New Zealand, has a 1%-3% range, with a focus to keep it near the 2% midpoint in the medium term.
The main argument against a point target as espoused by Kganyago would seem to be that it’s more likely to be missed more frequently, something that over time may reduce its credibility and lead price setters to rely on today’s inflation.
Another argument in favour of range is that it insulates the inflation-targeting process from the accusation it’s too narrowly focused on price increases at the expense of other considerations. One could argue that we are seeing the benefits now, with the central bank being about to support the economy with record-low interest rates even with inflation close to 5%.
While the study found that having a range led to less disagreement among forecasters, this wasn’t necessarily true in emerging economies. And even here it seems to suggest this was only the case when the range was missed completely.
As much as it might disappoint those in search of a clear-cut answer, the ECB paper would seem to suggest mainly that SA underperforming its peers on inflation outcomes might have little to do with it having chosen a range. Kganyago’s desired 3% target might not be a silver bullet.
It doesn’t seem that changing to a point target, and the political disputes it would entail, will deliver better inflation outcomes and enhance the credibility of the targeting regime. A tighter target range might do the trick.
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