Central Banks should rethink their inflation targets and lessen dependence on oil!
The financial crisis has tested Central Bank’s resolve, with accommodative monetary policy i.e negative interest rates and large scale bond purchases have done little to ensure a sustained convergence of inflation towards the 2.0% target. Stubbornly low inflation can be attributed to several factors such as competition stemming from an increasingly globalized market place, an overwhelming dependence on oil prices — as I argue here — and a weaker passthrough from the labor market to price pressures.
Central Bank inflation targets were always contingent on exogenous factors!
A majority of central banks have a mandate to pursue price stability. This has taken different forms, with the ECB pursuing inflation at or slightly below 2.0%, the FED explicitly targets 2.0% inflation & maximum employment and the BoE targets a symmetric 2.0% inflation target. As illustrated in the table below, New Zealand started the trend of inflation targeting after years of too-high inflation. Since its adoption in the 1990’s, some countries have adopted a target range i.e Canada (2% +/-1), Australia(2%–3%), Brazil (4.25 +/-2 — updated), Iceland (2.5% +/-1.5) and Norway (2% +/-1). Meanwhile, a point target is the anchor for monetary policy in the U.K(2.0%) and the United States(2.0%).
A target range facilitates the attainment of the inflation target as deviations are more readily explained and it also reflects more realistic outcomes. Despite their best attempts, Central Banks are unlikely to achieve the inflation target sustainably as headwinds, geopolitical and political uncertainty will likely cause transient deviations from the Central Banks inflation target. For example, a target range would have allowed the ECB to pause interest rates, allowing for the percieved de-escalation in the U.S. — China to persist. It was, however, impossible to pause as communicating a wait-and-see strategy to market participants will be inconsistent with the attainment of the inflation of its inflation target.
Such an approach is however justified as monetary policy would have been more effective and the transmissions to the real economy more readily felt via a tighter labor market, higher real income growth and a slow, but, gradual convergence of inflation towards the Banks’ inflation target. It is important to give credit to central banks’ inflation targeting and price stability. it reduced the cyclicality in households’ disposable income, which were previously exposed to higher prices for goods and services.
As illustrated above, inflation targeting set the foundations for inflation to fall to manageable levels and allowed for a more targeted monetary policy in that regard (see chart below). Euro Area inflation tended to fluctuate around the Central Banks’ 2.0% inflation target, but prolonged deviations from the target have become increasingly apparent following the 2008 GFC.
Is it time to rethink the inflation target?
Markets, media, and citizens have come to trust the inflation target, providing further legitimacy to central banks’ inflation target, but with inflation increasingly driven by exogenous factors and outcomes undershooting 2.0%, it might be time for a rethink of the inflation target. By no means will this reduce central banks’ inflation targeting credentials, but rather improve the ability of monetary policy to achieve the inflation target. Furthermore, they need not reduce the inflation target per se, but rather introduce a target band, which will serve as a tolerance range for deviations from an explicit target.
Inflation is increasingly driven by oil price
I argued in a recent paper that inflation is increasingly driven by exogenous factors such as oil prices. A recent paper from the ECB confirms this assertion, noting that headline inflation is currently dominated by a strong contribution from oil prices (see chart). Energy prices contributed 0.9% to HICP inflation, almost half of the Banks’ 2.0% target. This contribution is however heterogeneous amongst Euro area member countries and depends on consumer expenditure and the pass-through from oil prices to energy prices. The weight of energy in HICP does not explain differences amongst countries, as contributions of energy prices to headline inflation are above what would be implied by the weights (ECB, 2019).
Transport fuels account for half the energy weight in all countries as they follow changes to crude oil more closely than other energy components (see chart below). The difference in fuel price inflation across member countries can, therefore, be explained by other factors. The weights of energy and its main sub-items in HICP in 2018 are illustrated above.
Changes in excise taxes have an impact on fuel prices, and higher prices negate the impact of a passthrough from higher oil prices. Differences in VAT rates explain changes in prices for the consumer but not the extent or rate of passthrough. The total share of petrol prices vary across countries from around 50% in Luxembourg, Malta, and Spain to just above 60% in the Netherlands, Italy, and Greece, thus partly helping to explain differences in the final level of the fuel price and the pass-through of crude oil price changes to fuel prices. Differences in technology and buffering prices account for differing rates of passthrough of crude oil prices to fuel prices. However, this cannot be completely discounted over the short-term.
Meanwhile, the pass-through from oil prices to gas prices is less pronounced as electricity increasingly generated from a range of sources (wind, solar, nuclear, biofuels). As illustrated in the chart above, fuels and lubricants for personal transport equipment are closely correlated amongst a majority of Euro Area countries, with a faster rate of passthrough for gas in Cyprus than fuels and lubricants. Meanwhile, the passthrough from gas is highest in Slovakia, Portugal, Cyprus, and Greece.
Furthermore, gas and electricity prices are partially or fully regulated, limiting the extent of pass-through from oil prices, if at all. Euro Area countries have seen an increased contribution from oil prices to HICP inflation, and although dispersion exists, the transmission from oil prices to fuel prices persist (see chart illustrating correlation). This relationship is likely to wane, somewhat, in the future as oil prices fall and their passthrough lessen. A reassessment of Central Bank’s inflation target will improve the effects of monetary policy, keep inflation expectations anchored and reduce pressure on Central Bank’s balance sheet. It might take careful communication in other to prevent a market tantrum and its associated ills on households’ balance sheets, but a rethink of the inflation target is in order. Additionally, this will lessen the pressure on Central Bank's balance sheet, improve the ability of monetary policy to achieve a more appropriate inflation target and respond to a downturn.
Note: This article was first published on the Data-Driven Investor
Reference List.
- Ieva Rubene (ECB), The role of energy prices in recent inflation outcomes: a cross-country perspective. November 2018