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What does the current inflationary upsurge tell us about prospects for inflation in the long run? My focus here will be on the UK. However, the broader lesson may have implications elsewhere: central banks are unlikely to consistently meet their long-term targets. Inflation will likely exhibit asymmetry, with greater overshoots on the upside compared to the downside.
A couple of decades ago, I had a conversation with one of the Bank of England’s high-ranking officials who suggested that while the bank may not always precisely hit its 2% target, the errors should be symmetrical over time. The expected outcome in the long term should align with the price level implied by the 2% annual target. For decision-makers, this expectation for the future price level was just as crucial as annual inflation because it determined the real value of contracts denominated in sterling, such as bonds or annuities. If proven correct, the inflation targeting regime offered both short-term policy flexibility and long-term predictability of the price level. It seemed like an excellent combination and a solid justification for inflation targeting.
The recent surge in inflation raises doubts about the validity of these assumptions. It appears that they are not holding true.
Let’s turn back to 2003 when the UK’s target was tied to the consumer price index. Since then, the actual price level was seldom, if ever, slightly lower than the level indicated by a cumulative 2% inflation, even considering the long-term disinflationary shock caused by the 2007-09 financial crisis and its aftermath. However, the deviation was negligible. In February 2021, the price level only stood 2% higher than what could be expected from consistent success in achieving the target. It seemed like inflation targeting was delivering the desired stability in the price level.
Nevertheless, the story has taken a different turn since then. In June of this year, the consumer price level was 17% higher than what was implied by the target. This followed a cumulative rise of 21% in the price level over the previous three years. In less than a third of the time, the UK experienced the equivalent of almost 10 years of 2% inflation! By August, it appeared as if inflation had been running at a compounded rate of 2.8% since June 2003, rather than the intended 2%.
Until recently, policymakers were more concerned about falling short of the target. In the US, this led to a decision to counterbalance past shortfalls with future policy. The Bank of England did not face the same issue at the time. But let’s assume that past mistakes do matter. Even with no inflation, it would take until mid-2031 for the price level to reach the point it should have been at with 2% inflation from June 2003.
The bank is not obligated to rectify this. Nonetheless, this significant overshoot offers valuable lessons.
Firstly, it reveals that price levels are unlikely to experience a sharp downward crash, but they can easily surge upwards, as has been the case recently as well as in the 1970s. Secondly, policymakers are much more diligent in avoiding deflation than in dealing with above-target inflation. This is unsurprising as stimulating economic activity is much more favorable and easier to achieve than deliberately increasing unemployment rates.
Additionally, economists’ views are influenced by the state of the business cycle. There are valid arguments for questioning whether 2% is the optimal target. However, only a few advocated for lowering it in the aftermath of the financial crisis. More recently, influential economists have argued for a higher target due to the surge in inflation. Furthermore, as Soumaya Keynes highlighted, some economists are pointing out that tighter monetary policy may have long-term negative impacts on the economy. This is undoubtedly true. However, it was also expected that such arguments would arise during periods of high inflation.
In conclusion, I believe that monetary policy will exhibit asymmetry in the long run. During recessions, central banks will swiftly and decisively loosen policy, whereas during inflationary booms, they will be hesitant to respond as quickly. Consequently, average inflation is likely to exceed the target over the long term.
This is why I agree with the perspective of Catherine Mann, former chief economist of the OECD and current member of the Monetary Policy Committee. In a recent thought-provoking speech, she states, “I would rather err on the side of over-tightening.” The duration of high inflation matters because it increases the likelihood of people viewing 2% inflation as an unlikely long-term outcome. The evidence in the UK strongly suggests that it is indeed unlikely, and a rational individual should not believe otherwise.
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