Average inflation targets from a global perspective - Capital Economics
Global Economics

Average inflation targets from a global perspective

Global Central Bank Watch
Written by Jennifer McKeown
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For the past thirty years the orthodoxy has been that central banks should focus on controlling inflation, targeting a rate (normally 2%) over a key policy horizon (often 18 months to two years ahead). In his address to the annual Jackson Hole monetary policy symposium, US Federal Reserve Chair Jerome Powell signalled a break with that orthodoxy by announcing that the Fed would now adopt “a flexible form of average inflation targeting”.

  • Other central banks won’t follow the Fed immediately…
  • …but direction of travel is towards greater tolerance of inflation in advanced economies
  • Japan’s experience highlights that some will have more success than others

For the past thirty years the orthodoxy has been that central banks should focus on controlling inflation, targeting a rate (normally 2%) over a key policy horizon (often 18 months to two years ahead). In his address to the annual Jackson Hole monetary policy symposium, US Federal Reserve Chair Jerome Powell signalled a break with that orthodoxy by announcing that the Fed would now adopt “a flexible form of average inflation targeting”.

You can read more about the Fed’s shift as it relates to the US here. However, it raises some broader global considerations: How do average inflation targets work? What are the limitations and side effects? Is a similar change feasible or desirable elsewhere? And what would be the economic and financial market implications?


How might an average inflation target work?

Rather than always aiming to hit a specific inflation target at a particular policy horizon, central banks can aim to achieve inflation of a certain rate on average over a period of time. The key implication of such a policy is that, after a period of below-target inflation, a burst of above-target inflation will be actively targeted. And in theory, if inflation were above target for a period, the central bank would seek to keep it below target for some time thereafter. (Although the resulting requirement to keep unemployment artificially high would be controversial in practice.)

Average inflation targeting is distinct from standard inflation targeting as it assigns a role to past inflation outturns. Whereas standard inflation targets allow bygones to be bygones, average inflation targets do not. But the policy does not go quite as far as a price level target, under which a central bank would aim to make up for inflation shortfalls however long it took. Under average inflation targeting, inflation shortfalls drop out of the average after a few years and bygones can finally be bygones.

The timeframe for the average tends to be somewhat vague. The Reserve Bank of Australia (RBA), which has targeted average inflation since the early 1990s, aims for “a medium-term average inflation rate of 2 to 3 percent over the cycle”. Since 2016, the Bank of Japan (BoJ) has pledged to expand the monetary base until core CPI inflation exceeds 2% and “stays above that target in a stable manner”. And the Fed has so far stated only that it will “seek to achieve inflation that averages 2% over time” [our emphasis in each case]. On the one hand, clarity aids transparency and credibility. But on the other, more loosely specified targets allow central bankers some flexibility to interpret them as they see fit under the circumstances.

In the current context where the world economy has experienced a deep recession and inflation is low, average inflation targets have two main advantages over standard ones. First, they should allow nominal interest rates to stay lower for longer as they grant central banks leeway to let inflation rise as the economic situation improves.

Second, they can offer additional policy stimulus by boosting inflation expectations. Economic agents and financial markets have come to trust central banks in major advanced economies to achieve their inflation targets during “good times”. But when a recession hits, they know from experience that inflation will undershoot. Therefore, over longer periods, it is reasonable for them to expect inflation to average less than the target (as indeed it has in most advanced economies). If central banks can credibly commit to allow inflation to rise above target following any undershoot, then medium- and longer-term inflation expectations should rise. This will lower real interest rates, thereby offering additional policy stimulus even when nominal rates are at their lower bound.


What are the limitations and side effects?

One key limitation of average inflation targets is that yields are already incredibly low across the curve in all major advanced economies. There is therefore very little scope for a reduction in nominal interest rate expectations to reduce borrowing costs.

Inflation expectations are therefore the most important channel, and they have indeed risen somewhat in the US since the Fed’s announcement. However, credibility is crucial and the extent to which a rise in inflation expectations can be achieved depends on whether people believe that the bank has the tools and the determination to achieve its goal (more on this later).

Average inflation targets also have several potential side effects. First is the risk of runaway inflation. While this may seem a long way off for the economies in question, inflation is notoriously difficult to control once it is unleashed. It may be that this commitment prevents the rapid action that would otherwise be taken to address the first signs of mounting price pressures.

Another downside is the risk of stoking asset price bubbles. Even if inflation rose only a little above target, the efforts required to achieve that could cause unsustainable increases in house prices or other asset prices.


Is a similar change feasible or desirable elsewhere?

This leads us to whether more central banks will follow in the footsteps of the Fed. In most cases, such a move could be justified. Inflation has fallen short of target in all of the major advanced economies on average over the past five years. (See Chart 1.)

None seem likely to mimic the Fed immediately. But change may well be afoot in the future, with the ECB, the Bank of Canada and the Bank of England all undertaking reviews of their monetary policy strategy next year. The ECB has the power to set its own definition of price stability, while the Bank of Canada does so in consultation with the government. The Bank of England’s target is set by the UK Government, but with public debt surging the Chancellor might well welcome a combination of low interest rates and higher inflation.

Chart 1: CPI Inflation (average over past 5 years, %)

Sources: Refinitiv, Bloomberg, Capital Economics

On the face of it, the fact that inflation has averaged close to 2% in Canada suggests that the Bank of Canada has relatively little to gain in copying the Fed. But it has voiced growing concerns about the distribution of income and wealth. An average inflation target would allow it to hold off from pre-emptive interest rate hikes that might weigh on a nascent labour market recovery. We think that such a change in target might come next year. (See here.)

The ECB has greater justification given that inflation expectations there seem to have been further below 2% than those in the US ever were. (See Chart 2.)

Chart 2: 5Y-5Y Inflation Swaps (%)

Sources: Refinitiv, Bloomberg, Capital Economics

But the ECB was already a step behind the Fed since its current 2% target is an asymmetric one (“below, but close to, 2%”). The most likely outcome of its strategy review, which concludes late next year, will be a shift to a symmetric target of 2%. But it could add that it aims to achieve this target “on average over time” rather than simply “over the medium term”. (See here.)

The Bank of England seems unlikely to shift to an average inflation target. Inflation and inflation compensation have been higher in the UK than the US over recent years and the Monetary Policy Committee will resist any changes by the government that could be seen to reduce the Bank’s independence or credibility. But by strengthening its forward guidance and announcing an extra £250bn of QE in time, we think that the Bank will achieve similar results to the Fed. (See here.)


What would be the economic implications?

In any case, boosting inflation to compensate for periods of undershooting is likely to be easier said than done. In the near-term, sizeable output gaps will continue to bear down on inflation in most places. And beyond this, many of the structural forces that have combined to flatten Phillips Curves over the past decade or so are likely to persist.

The introduction of a 2% inflation target in Japan in 2012 and the pledge to allow inflation to overshoot that target in 2016 have done little to lift the inflation expectations of households and firms. That failure has little to do with a lack of action by the Bank of Japan, which now owns nearly 50% of outstanding government bonds, has launched negative interest rates and introduced a target for 10-year government bond yields. Instead, it reflects the fact that expectations of falling prices and incomes have become deeply engrained following two decades of deflation. (See here.)

The key point is that, whether it is through average inflation targets, symmetric targets, ranges or simple forward guidance, the direction of travel for major central banks is clearly in favour of tolerating higher inflation as economies recover. Their intent is to keep real interest rates as low as possible for as long as possible. But some will have more success than others. The ECB may find that, like the Bank of Japan, it is already too late. The Fed and the Bank of England have a better chance of boosting inflation, but the question of course is whether they will stoke it too far. We assess this risk in detail in a forthcoming Global Economics Focus.


Recent Monetary Policy Developments

Review of recent policy rate changes

The global easing cycle has slowed over the past couple of months – of the 20 central banks covered in this document, just two reduced their key policy rate in August, while the rest kept rates unchanged. (See Chart 3.) With much of Latin America still facing particular difficulty in containing the coronavirus, it is perhaps unsurprising that it was the Brazilian and Mexican central banks that cut interest rates in August – policy rates fell by a further 25bps and 50bps, respectively.

Chart 3: Changes in Benchmark Rates

Source: Bloomberg, Capital Economics

Among advanced economies, the rapid increase in central banks’ balance sheets that occurred in the early stages of the pandemic has continued to lose momentum in recent weeks. (See Chart 4.) The Fed, in particular, has reduced its purchases of Treasury securities from $350bn per week to slightly less than $20bn per week – close to pre-pandemic levels.

Chart 4: Central Bank Balance Sheets as % of GDP

Sources: Refinitiv, Capital Economics

Looking ahead, we suspect that most major advanced economy central banks will increase the pace of their purchases again. However, since the last Global Central Bank Watch, we have pushed back our expectations of further loosening in most cases until next year.

In the US, the flattening of the balance sheet over recent months has reflected very low take-up of the Fed’s new 13(3) emergency lending facilities. Officials are eyeing a return to a more traditional QE program to counteract this, although it seems unlikely that they will act this year.

Elsewhere, the pace of purchases at the ECB will probably pick up after the summer lull. We expect that the Pandemic Emergency Purchase Programme will be expanded by a further €500bn, albeit not until next March. And in the UK, we expect the Bank of England to expand QE by a further £250bn in total by the end of 2021.

Meanwhile, proposals by the Australian banking regulator and the Reserve Bank of Australia that banks will need to hold more government bonds look like a form of financial repression. But given that these requirements will be phased in slowly, we suspect that their impact on funding costs will be small. As such, we still expect the RBA to launch additional government bond purchases next year.

New Zealand and Sweden to cut rates below zero

While interest rates in most advanced economies are now at their floor and are set to remain there for at least the next two years, there are a couple of exceptions. (See Table 1.)

Table 1: Summary of CE Forecasts for Policy Rate
Net Changes by the End of 2020

Policy Direction

Economies

Easing

Sweden, China, India, Brazil, Russia, Mexico, South Africa

No Change

US, UK, Euro-zone, Japan, Canada, Australia, New Zealand, Switzerland, Denmark, Norway, South Korea, Turkey, Poland

Tightening

Source: Capital Economics

Notably, the RBNZ looks set to cut interest rates into negative territory for the first time – we expect the benchmark rate to drop from 0.25% now to -0.25% early next year.

Meanwhile, in Sweden, we expect weak price pressures to convince the Riksbank to reverse its recent hike in the repo rate later this year.

More dovish than investors in most EMs

With the economic outlook remaining weak in most EMs, we expect monetary policy to be loosened further and by more than markets expect in the coming months. Admittedly, the number of EM central banks cutting interest rates fell last month and will probably continue to do so over the rest of this year. But that is mostly due to the fact that in several EMs, including Poland and Korea, nominal policy rates are now at, or close to, their floor.

In countries such as Russia, Mexico and India, where interest rates were much higher coming into the pandemic, policy rates should continue to decline this year. And elsewhere, central banks including in Poland and Korea look set to either introduce or expand unconventional monetary policy measures.

The key exception is China where, with fiscal policy becoming more supportive and activity rebounding, the People’s Bank of China (PBOC) no longer sees the need to push interest rates down further. In fact, the PBOC has been more hawkish in recent weeks and we now think that the next move in policy rates will be upwards – although not until next year.

Another exception is Turkey. While the central bank left its key rate on hold in August, it has been using other monetary policy tools, such as its interest rate “corridor” to tighten policy. With the lira set to remain under pressure, further back-door tightening is likely.

Table 2: Central Bank Policy Rates

Country

Policy rate

Latest

Last Change

Next Change

(CE Forecast)

 

End-2020

End-2021

End-2022

Major Advanced Economies

      

US

Fed funds target

0.00-0.25

Down 150bp (Mar. 2020)

None on horizon

 

0.00-0.25

0.00-0.25

0.00-0.25

Euro-zone

Deposit rate

-0.50

Down 10bp (Sep. 2019)

None on horizon

 

-0.50

-0.50

-0.50

Japan

Interest on excess reserves

-0.10

Down 10bp (Jan. 2016)

None on horizon

 

-0.10

-0.10

-0.10

UK

Bank Rate

0.10

Down 65bp (Mar. 2020)

None on horizon

 

0.10

0.10

0.10

Other Advanced Economies

      

Canada

Overnight target rate

0.25

Down 150bp (Mar. 2020)

None on horizon

 

0.25

0.25

0.25

Australia

Cash rate

0.25

Down 50bp (Mar. 2020)

None on horizon

 

0.25

0.25

0.25

Switzerland

Sight deposit rate

-0.75

Down 50bp (Jan. 2015)

None on horizon

 

-0.75

-0.75

-0.75

Sweden

Repo rate

0.00

Up 25bp (Dec. 2019)

Down 25bp (Q4 2020)

 

-0.25

-0.25

-0.25

Denmark

Deposit rate

-0.60

Up 15bp (Mar. 2019)

Down 15bp (Q4 2020)

 

-0.75

-0.75

-0.75

Norway

Sight deposit rate

0.00

Down 25bp (Apr. 2020)

None on horizon

 

0.00

0.00

0.00

New Zealand

Cash rate

0.25

Down 75bp (Mar. 2020)

Down by 25bp (Q1 2021)

 

0.25

-0.25

-0.25

         

Major Emerging Economies

      

China

7-day reverse repo rate

2.20

Down 20bp (Mar. 2020)

Up 10bp (Q1 2021)

 

2.00

2.40

2.40

India

Repo rate

4.00

Down 75bp (Mar. 2020)

Down 25bp (Q4 2020)

 

3.75

3.50

3.50

Brazil

Selic rate

2.00

Down 25bp (Aug. 2020)

Up 25bp (2022)

 

2.00

2.00

3.00

Russia

1-week repo rate

4.25

Down 25bp (Jul. 2020)

Down 25bp (Sep 2020)

 

3.75

3.50

3.50

Mexico

Overnight target rate

4.50

Down 50bp (Aug. 2020)

Down 25bp (Sep 2020)

 

3.75

3.75

3.75

South Korea

Base rate

0.50

Down 25bp (May 2020)

Down 25bp (Q3 2020)

 

0.25

0.25

0.25

Turkey

1-week repo rate

8.25

Down 50bp (May 2020)

None on horizon

 

8.25

8.25

8.25

Poland

Reference rate

0.10

Down 40bp (May. 2020)

Up 25bp (2022)

 

0.10

0.10

0.50

South Africa

Repo rate

3.50

Down 25bp (Jul 2020)

Down 25bp (Sep 2020)

 

3.00

3.00

4.00

         

Sources: Bloomberg, Capital Economics.

 

Table 3: Quantitative Easing & Other Unconventional Policies
Sources: Central banks, Capital Economics.

Table 4: Calendar of Policy Decisions

Date

Economy

Policy Instrument

Prior

Survey

CE Forecast

9th September

Canada

Overnight Target Rate

0.25

0.25

10th September

Euro-zone

ECB Deposit Rate

-0.50

-0.50

15th September

Poland

Reference Rate

0.10

0.1

 

Brazil

Selic Target Rate

2.00

2.00

16th September

United States

Fed Funds Target Range

0.00-0.25

0.00-0.25

17th September

Japan

Interest on excess reserves

-0.10

-0.10

 

United Kingdom

Bank Rate

0.10

0.10

 

South Africa

Repo Rate

3.50

3.00

18th September

Russia

1-week repo rate

4.25

4.00

20th September

China

7-day Repo Rate

2.20

 

2.20

21st September

Sweden

Deposit Rate

0.00

0.00

23rd September

New Zealand

Cash Rate

0.25

0.25

24th September

Switzerland

Policy Rate

-0.75

-0.75

 

Norway

Policy Rate

0.00

0.00

 

Turkey

7 Day Repo Rate

8.25

8.25

 

Mexico

Overnight Lending Rate

4.50

4.25

1st October

India

Reverse Repo Rate

4.00

4.00

6th October

Australia

Cash rate

0.25

 

0.25

7th October

Poland

Reference Rate

 

0.10

14th October

South Korea

Base Rate

0.50

0.25

22nd October

Turkey

7 Day Repo Rate

8.25

23rd October

Russia

1-week repo rate

27th October

Brazil

Selic Target Rate

 

2.00

28th October

Canada

Overnight Target Rate

0.25

29th October

Euro-zone

Deposit Rate

-0.50

 

Japan

Interest on excess reserves

-0.10

2nd November

Russia

1-week repo rate

 

3rd November

Australia

Cash Rate

 

Brazil

Selic Target Rate

 

2.00

4th November

Poland

Reference Rate

0.10

5th November

Norway

Policy Rate

0.00

 

United Kingdom

Bank Rate

0.10

 

United States

Fed Funds Target Range

0.00-0.25

Sources: Bloomberg, Capital Economics


Jennifer McKeown, Head of Global Economic Service, jennifer.mckeown@capitaleconomics.com
Gabriella Dickens, Global Economist, gabriella.dickens@capitaleconomics.com