Central banks squandered their chance to keep inflation under control, and it is not sure that their game of catch-up will work.
Inflation will come down naturally – or will remain higher than it was before the Covid pandemic, and central banks will need to raise their targets.
Since the financial crisis of 2007-2009, central banks had been printing money on a scale never before seen in history.
The inflationary consequences of this largesse have manifested themselves in financial assets and property prices, but not in consumer prices.
However, the wave of money-printing during the Covid pandemic and subsequent high inflation have been closely linked.
“Across countries, there is a statistically and economically significant positive correlation between excess money growth in 2020 and average inflation in 2021 and 2022,” a recent paper released by the Bank for International Settlements shows.
It also shows something much more worrying:
“Across countries, there is a statistically and economically significant positive relationship between excess money growth in 2020 and professional forecasters’ misses of inflation in 2021 and 2022,” according to the BIS paper.
In other words, central bankers missed the fact that their quantitative easing policies would push consumer prices up.
Maybe this is because for so long, their money-printing only sent stock, bond and real estate markets higher. When consumer price inflation finally reared its head, they said that it would be “transitory” rather than entrenched.
They quickly changed their tone and have been trying to play catch-up with series of interest rate rises, but the truth is, unless a deep recession takes place, inflation could stay high for years.
Central banks would need to hike rates so high and consequently reduce demand so severely to bring inflation down to 2%, that they would risk sparking protests or even riots.
The most likely scenario is that they will simply choose to raise the inflation target instead. But to what level?
One option would be to double it to 4% — not as high a target as to completely destroy their credibility, and not as low as to see deep pain inflicted when trying to slow the pace of price rises towards it.
A doubling of the inflation target would also make it easier for governments to reduce the mountain of debt they accumulated since the financial crisis. Higher inflation erodes the value of the debt already issued, and therefore transfers the pain on to bondholders.
With interest rate hikes expected to slow in order to avoid causing too much pain to the consumer, a decision on raising the inflation target seems a matter of when, rather than if. Investors should start to take this into account.