The Strategist

A look at the inflation targeting of central banks

The inflation target of many central banks remains an integral part of monetary policy and the financial world. We name four reasons why Western central banks are targeting two percent inflation. In our view, portfolio risk should not be increased as there is an attractive alternative with short-term bonds. 

Date
Author
Thomas Wille
Reading time
10 minutes

A look at the inflation targeting of central banks
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In recent months and quarters, investors have been trying to determine whether the peak in the inflation trend in the US and in Europe has already been passed. Will the wage and/or service inflation last longer than the central banks would like? With the publication of new data in the US and the eurozone, hopes are regularly raised that a disinflationary environment will soon return. This then often leads to increased volatility in risky assets. However, what is always in focus for central banks as well as investors and the media are the inflation targets imposed by the central banks themselves. What matters to capital markets is when these targets can be achieved and what is the potential economic cost of doing so?

The emergence of inflation targeting

What now seems like the holy grail of modern monetary policy was not initiated until the early 1990s – the two percent inflation target of major central banks. Surprisingly, neither the US Federal Reserve nor the Bank of England was at the forefront of creating this target, but it was the Reserve Bank of New Zealand under the leadership of then Governor Donald Thomas Brash. In 1990, the Reserve Bank of New Zealand (RNBZ) became the first central bank to set an explicit inflation target with a target range of 0-2%. The aim was to establish a clear, transparent and independent monetary policy framework with an explicit inflation target. In the following years, the Bank of Canada as well as Australia's central bank followed New Zealand's example when they also introduced an inflation target of two percent. The Bank of England, the German Bundesbank and the Federal Reserve also set such an inflation target in subsequent years.

Why two percent?

Western central bank’s target two percent inflation for four reasons:

Price stability: the inflation target is viewed by central banks as a level that ensures price stability as defined in the mandate and is critical to promote economic growth and stability.

Anchoring inflation expectations: A two percent inflation target helps anchor expectations about future inflation developments, which reduces uncertainty and promotes stability in the economy.

Promoting growth: By targeting a moderate level of inflation, monetary policy can help central banks foster economic growth by creating a stable and predictable environment for economic activity.

Avoiding deflation: inflation targeting helps to reduce the risk of deflation, which is a prolonged and widespread decline in prices that can damage the economy.

Overall, the two percent inflation target is viewed by central bankers, economists, and financial markets as an important tool to promote stability and growth in the economy.

No foreseeable departure from the target

For Western central banks, the inflation target is synonymous with creditability. During the first two decades in this century, central banks mostly succeeded very well in doing so. Accordingly, it probably makes little sense at this point in time to think or philosophize about whether, in the near or distant future, monetary guardians will deviate from this objective. However, there would be some weighty reasons: for example, de-globalization, reshoring or energy security. We believe that central banks will continue to stay committed to restoring price stability at all costs, even if the price is a recession. Against this backdrop, we believe that risk in portfolios should not be increased, especially as there is an attractive alternative on the fixed income side in the form of short-term bonds. 

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