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Earlier this month, the doughty institution that is the United Nations Conference on Trade and Development issued its annual report. This included a novel twist: an appeal for western central banks to rethink their mandates.
Yes, really. “Central bankers should relax their 2 per cent inflation target and assume a wider stabilising role,” the Geneva-based group declared, lamenting that “tighter monetary policy has so far contributed little to price easing [but delivered] a steep cost in terms of inequality and damaged investment prospects.”
I doubt financial traders will pay any attention; to them Unctad is merely a stodgy bureaucracy. Nor will Jay Powell, chair of the Federal Reserve, or his counterparts in Europe and the UK.
After all, the mantra from those central bankers is that the 2 per cent target is (still) a sacred medium term goal. And officials such as Powell insist that inflation is steadily drifting down from last year’s sky-high levels — and should continue to do so. That is partly true: in America, say, the consumer price index in September was 3.7 per cent — while in the UK it was 6.7 per cent.
But stodgy or not, Unctad’s report is a notable straw in the wind. For it crystallises a question I have repeatedly heard muttered by public and private sector voices: is there any point in retaining that two per cent target in a world where inflation seems likely to remain above this level for the foreseeable future — even if it is “only” around four?
Or as one Fed regional president told me this summer, after touring local companies: “Everyone keeps asking if three [per cent] is the new two.”
These questions seem set to become more, not less, intense in the coming months, particularly given the ghastly events now unfolding in the Middle East.
This is not necessarily due to the scenario that is currently worrying some investors — namely that this conflict will disrupt energy supplies in a way that replicates the 1973 oil shock. During that crisis, the oil price tripled, creating a wage-price spiral in the west and badly damaging growth.
“This time will be different,” says Phil Verleger, an energy economist who cut his teeth during the 1973 shock. This is because the rising use of renewables is enabling diversification away from oil, and current events will probably accelerate that. But energy usage has also become more efficient: the IMF calculates that there is now 3.5 times more growth per barrel of oil than 50 years ago.
But even if an exact replay of 1973 is unlikely, oil prices have already drifted up, and are likely to continue in a way that will undermine chances of further falls in inflation.
Meanwhile labour costs in places such as the US and UK are showing only moderate declines. Service inflation remains marked and American housing costs are being raised by supply constraints.
Geopolitics are also reshuffling supply chains in an inflationary manner, and this fracture could get worse; Ray Dalio, the founder of Bridgewater thinks the odds of a “global hot war” have now risen to 50 per cent, compared to 35 per cent two years. Thus the risk haunting investors is not “just” a replay of the 1970s, but also the 1930s — and war tends to be inflationary.
This means that the pernicious problem for central bankers is that prices are no longer being shaped “just” by demand cycles, of the sort they have spent decades analysing and trying to control; instead, as we first saw during the Covid-19 pandemic, and are now seeing today, it is supply issues, for which they have far fewer tools.
On top of this, some economists suspect that American consumer demand cycles are being smoothed out by swelling government subsidies, further blunting their traditional analysis.
This means that if central banks wanted to be certain of hitting their 2 per cent inflation target any time soon, they would need far bigger rate increases than they (or anyone else) initially expected.
For example, Kevin Hassett, former White House Chief Economic Adviser, says models using the so-called Taylor rule suggest that US rates would need to rise from the current 5.25 per cent to 6 or 7 per cent; some estimate even higher.
Increases of that magnitude would be unpopular with consumers. It would also hurt banks, as we saw earlier this year. Non-financial companies would suffer too, given that almost $2tn corporate debt must be refinanced in the next two years. And while that only represents 16 per cent of the total, it is enough to matter.
So what will central banks do? Raise rates enough to hit that 2 per cent target? Publicly admit that three (or even four) per cent is the new two? Or tacitly downplay the goal until something — anything — changes the supply-side factors and/or full-blown recession hits?
My bet is on the third option. It is also probably the least bad one amid these unpalatable choices. But sensible or not, this strategy also smacks of burgeoning hypocrisy — and, most importantly, a whiff of impotence.
Either way, the key point that investors need to understand is that while economists used to quip that central banks were the “only game in town” because markets danced to their tune, now they are being eclipsed by geopolitics. No wonder Treasury yields keep rising.
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