The 2% target: credibility, realism, and the central bank mandate
Summary
The persistence of inflation has prompted a fundamental question regarding the cornerstone of modern monetary policy: Is the 2% inflation target still realistic, or should central banks adjust it to a higher range to reflect a new environment? While the idea of a "bit of realism" appeals to some, most central banks are resisting changes. There would certainly be a credibility question for some if the target were to be altered.
The commitment to 2% is a powerful tool. On our last semiannual market update webinar, Jackie Bowie, Chatham Financial’s Head of EMEA, asserted that any formal "movement of the target to either a range or a different level altogether... starts to really question central bank credibility." Historically, central bank independence, such as that granted to the Bank of England, was explicitly intended to reinforce the focus on inflation and provide comfort and stability to consumers and to the financial markets. Undermining that mandate, by changing the goalposts, could risk long-term market trust.
Jackie Bowie, Chatham FinancialAny formal "movement of the target to either a range or a different level altogether... starts to really question central bank credibility."
The reality is, however, that most central banks do demonstrate a degree of flexibility. For instance, the ECB uses language of "tolerance," indicating a willingness to tolerate inflation slightly above or below the 2% level. However, past attempts at formalized flexibility have proven problematic. On the same webinar, Amol Dhargalkar, Chatham Financial’s Chairman, talked about the U.S. Federal Reserve’s position on "average inflation rate targeting." Since 2020 the Fed has used a framework called flexible average inflation targeting which aims for inflation that averages 2% over time. Although there is no formally defined average period, and there is no strict mathematical average window. The practical implication therefore is that the markets still treat 2% as the anchor level.
Amol Dhargalkar, Chatham FinancialThe U.S. Federal Reserve has used a flexible “average inflation rate” approach targeting 2%.
While sustained inflation above 2% in the UK and the US has tested public confidence, abandoning or revising the target could be a far more damaging response. Central bank credibility depends less on uninterrupted success than on consistency of purpose. Raising the target after a prolonged overshoot would amount to ex-post validation of failure, un-anchoring inflation expectations at precisely the moment they need reinforcing.
This article is part of Capital markets: strategy and risk, our Insights series where our leaders and experts help you navigate the complexities of today's capital markets and make informed and strategic decisions.
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Disclaimers
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