This week’s milestone G7 interest rate cuts dispel any notion that hitting 2% inflation targets spot on is a precondition for central bank moves or indeed sensible - and may guide thinking on the Federal Reserve and Bank of England too.
The European Central Bank and the Bank of Canada, covering four of the G7 major economies, cut interest rates on Wednesday and Thursday in the first reversals of some two years of policy tightening aimed at reining in post-pandemic inflation spikes.
In well-telegraphed moves, both announced the cuts even with headline inflation rates still above 2.0% targets - 2.6% in the euro zone and 2.7% in Canada. “Core” rates excluding energy and food and other volatile prices are just as high.
Have they rashly jumped the gun?
The reasons are well documented - the central banks continue to insist the targets will be hit, they forecast success on that front over the next year or two and claim policy is being pre-emptive by removing just a notch of restraint on slow-growing economies.
But the timing also reveals the degree of latitude central banks see around what might appear like precise targets - and how getting inflation to within one-tenth of one percentage point of a fairly arbitrary goal may be a fool’s errand anyway.
Many policymakers and economists doubt the wisdom of exact point targeting - citing numerous supply-side distortions in many components of inflation baskets and fretting about wider damage to economies simply in order to ring a 2% bell.
Having successfully punctured inflation rates to a quarter of the peaks seen in 2022, the risk of forcing recession and a rise in unemployment just to zap a final half percentage point seems to some an overly high price.
That’s especially so if - as their own forecasts and financial market pricing seems to suggest - the risk of a significant re-acceleration of inflation is seen to be low.
The debate then shifts to degrees of policy “restrictiveness” - judged mainly by how far current policy rates are above assumed “neutral” levels that would no longer bear down on or stimulate economic activity.
That in itself leaves a lot of wiggle room for most central banks.
Even if there’s considerable uncertainty on exactly where those largely theoretical neutral rates lie, most experts agree they are much lower than now - allowing central banks to claim a foot’s on the brake even as they pare back borrowing rates.
Estimates by ECB and BoC officials themselves, and indeed from Fed policymakers, indicate neutral policy rates have likely crept higher since the COVID-19 pandemic but they are still almost half the current levels.
The ECB and BoC were at pains to stress this week that the first cuts don’t necessarily presage a series that would wipe out monetary restriction altogether and they continue to monitor everything from sectoral price pressures to wage developments.
ROOM TO MANOEUVRE
But restriction aside, central banks’ formal targets themselves are not always as rigid as they seem either.
The Bank of Canada, for example, continually refers to its 2% target in public, but its most recent framework agreement with government covering the 2022-2026 period refers to the 2% target as a mid-point of a 1%-3% “inflation-control range”.
As Canadian inflation has already spent some four months below the upper end of that range, it’s not hard to see the green light to ease with the local economy slowing sharply.
For 18 years, the ECB used to have a target to get inflation “below but close to 2%,” but its 2021 strategy review adopted a more symmetric target around 2% “over the medium term” - which at the time was aimed at addressing years of undershoot and acknowledging that an averaging over the time was better.
And even though it nudged up its 2024 and 2025 inflation forecasts a touch while cutting rates on Thursday, the ECB still expects inflation to average as low as 1.9% in 2026.
For the Fed, which holds a policy meeting next week, inflation captured by its core PCE gauge is now similar to equivalents faced by the ECB and BoC - but it’s hesitating on rate cuts due to a much stronger economy and looser U.S. fiscal stance.
However, the U.S. central bank preceded the ECB in a shift of strategy in 2020 toward long-term averaging of inflation in assessing its target.
Although it’s publicly sidestepped that approach during the latest battle - with its next review expected some time next year - the whole approach de-emphasizes the idea of hitting 2% precisely at any one point as the only policy trigger.
What’s more, the Fed’s solo 2016-2019 tightening campaign to bring policy rates back up to neutral was also conducted even when core PCE rates languished below 2% for all but two months of that period. In other words, the return to neutral policy rates then didn’t require inflation to be bang on target.
That same argument could be applied in reverse now.
For investors, the bias from here will likely be more restrictive policy on average in the years ahead.
But that probably shouldn’t prevent some cuts from here.
“What is not being openly discussed, certainly by policymakers, is that we might not be able to get back below 2% without a severe recession,” said Chris Iggo, chair of the AXA IM Investment Institute, adding that just keeping a lid on inflation here may now see policy rates in a 3%-4% range on a longer-term basis in the U.S. and the United Kingdom and at some 2%-3% in the euro zone.
“How far above that range rates go depends on the appetite for forcing inflation back down through engineering a recession, an increase in spare capacity and higher unemployment,” he wrote. “Living with inflation a little above the target range has greater social utility than the alternative.”
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