We need to talk about inflation targets

Monetary policy is at a critical juncture. After decades of low and stable inflation, the seismic supply adverse shocks and robust demand of recent years have jolted inflation expectations. Now, the largest and likely to be the most persistent inflation overshoot we’ve seen in the inflation-targeting era is fuelling debate about whether inflation targeting is fit for purpose.

What you will learn:

• We don’t think inflation expectations have become unanchored. But they are clearly less grounded than policymakers had hoped. In a world of more common adverse supply shocks, the risk that inflation expectations may dislodge further is a real threat. This is a huge change to the challenges monetary policymakers face.
• At the start of this cycle, central banks were late to tighten, partly because they were too confident that expectations would remain low and stable. In the years ahead, it will be monetary policy’s role to limit the second-round impacts on wage and price-setting from supply shocks on inflation via managing expectations.
• A key question for future policy rate cycles is whether the post-pandemic lessons have been learned. If policymakers remain vigilant to expectations, then early and aggressive rate-hiking cycles will prevail. If they don’t, then delayed and ultimately even bigger hiking cycles with persistently higher rates will become the norm.