Shifting the inflation goalposts
As the most aggressive wave of monetary tightening in four decades slows the world’s largest economies, a growing number of analysts are questioning whether central banks should raise their inflation targets beyond the current 2%.
After all, is it worth sacrificing growth just to gain an extra inch in the fight against inflation?
But as Brazil’s recent economic difficulties demonstrate, the tradeoff between supporting GDP growth and fighting inflation cannot be wished away.
Ultimately, accepting slightly higher price levels by raising central-bank targets will most likely result in both higher inflation and a weaker economy.
Amid pressing security and climate-related challenges, policymakers may be tempted to move the goalposts when it comes to price stability.
For most of the past 15 years, developed economies struggled to generate inflation, with the US Federal Reserve and other central banks often falling short of their 2% target rates.
But the Covid-19 pandemic, the escalating tensions between the United States and China, and Russia’s attack of Ukraine have led to persistent supply-chain constraints, fundamentally altering the inflation landscape.
Similarly, the evolving nature of globalisation and the cleanenergy transition are prompting companies to rethink how they manage the supply of goods and labour.
This shift, together with the unanticipated shocks that could accompany it, is likely to have inflationary effects. But in light of the threat posed by climate change and heightened geopolitical tensions, one could argue that tolerating modestly higher inflation is the cost of achieving a just green transition.
The growing recognition that the current confluence of shocks requires significant changes in how our economies function represents a healthy development. The ongoing debate about inflation and growth, however, often fails to appreciate the fickleness of business and consumer confidence.
Brazil underscores the dangers of trying to adjust the anchors of price stability, even by a small margin. Shortly after President Luiz Inácio Lula da Silva publicly suggested that Brazil’s inflation target was too low and that elevated interest rates were stifling the economy, the central bank’s inflation expectations rose to 5.8% for 2023 and 3.6% for 2024.
The central bank, which gained formal operational independence only in 2021, has gradually lowered its target rate from 4.5% in 2018 to 3.25% for this year and 3% for 2024.
In response to the updated inflation expectations, markets promptly adjusted their own earlier expectations of a rapid, aggressive rate-cutting cycle and priced in a slower, more gradual downward trajectory.
At the longer end of the government debt yield curve, the risk premium that investors demanded to hold long-term Brazilian debt also sharply increased.
Real interest rates surpassed the 6% level that prevailed prior to October’s presidential election – and which were already perceived as exorbitant and unsustainable.
Given Brazil’s well-known history of hyperinflation and extreme inequality, achieving price stability is particularly urgent. But the ever-present threat that the country’s distorted fiscal regime of high taxes and spending poses to debt sustainability is often overlooked.
In the wake of the pandemic, government debt levels reached a 20-year high, leading to a significant increase in the cost of funding Brazil’s deficits even as growth rebounded.
While developed economies are not Brazil, rich-country policymakers must not assume that it would be any easier for them to persuade their citizens that higher inflation targets could be achieved at little additional cost.
Brazil’s experience offers three valuable lessons for determining whether central banks in developed countries should set higher inflation targets.
First, inflation targeting is essentially a confidence trick. If governments are perceived to be raising inflation targets to support higher levels of spending – regardless of whether this spending is needed or not – borrowing costs will inevitably increase for everyone.
In this scenario, re-anchoring inflation expectations at a higher level will almost certainly lead to a recession, which may be necessary to reduce inflation below the new target and keep it at that level long enough for expectations to stabilise.
Second, changing inflation targets without implementing fiscal consolidation would be imprudent. If the reason for resetting the target is to accommodate fiscal spending, it is unlikely that the public would believe that the reset is permanent.
Concern about fiscal sustainability has always been at the core of Brazil’s inflation problems.
Moreover, adopting a Brazilstyle regime of tight money and loose fiscal policy would limit private-sector investment opportunities and hamper job growth. It could also lead to a significant increase in interestrate volatility.
Third, the limitations of inflation targeting are particularly evident in times of greater supply-side uncertainty, as monetary policymakers have no advantage in determining whether a given supply shock is transitory or persistent.
In a low-inflation environment, policymakers could afford to wait to see whether a supply shock (of which there were few in recent decades) would naturally dissipate.
But in a world where inflation is already exceeding targets, and the risk of compounding shocks is high, policymakers do not have the luxury of time.
Thanks to their prior experience in dealing with persistent supply shocks, Brazilian policymakers had a better sense of the threat posed by today’s supply-chain disruptions than most central banks in developed economies.