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Why target inflation at 2.00%? A lesson in history is required. Economics is a not an exact science like physics or mathematics. Economics is born out of people’s urge to model uncertainty when combining the production factors. When adding the behavioural volatility corporate decision-making induces on trade, finance and politics, the complexity increases. Inflation targeting started as an experiment by the New Zealand Central Bank back in 1989. With inflation raging at 7.6%, the newly appointed president of the central bank, Don Brash, proposed and decided to conduct monetary policy so as to steer inflation between 0% and 1%. That target got adjusted shortly thereafter to 0% to 2%, and -hurray- inflation effectively hit 2% by the end of 1991. This experiment did not go unnoticed. Whilst most central banks moved from currency pegs towards managing money supply growth targets throughout the 80s and early 90s, inflation targeting by the RBNZ quickly became mainstream. The very moment national debt offices in the US and France kicked off on issuing inflation-linked government bonds around 1997 & 1998 respectively, central banks pushed inflation targets into their communication strategy and finally into their monetary policy strategy.
Both Volcker and Greenspan predicated that inflation should not be a factor in business decisions. Both adhered to the belief that 0% inflation might be optimal in preserving and holding the purchasing value of the currency stable. However, in 1995 Janet Yellen countered that 0% inflation could paralyse the economy. As member of the FED board of governors between 1994 and 1997, she stated: “ To my mind, the most important argument for some low inflation rate is the ‘greasing-the-wheel’ argument”. It offers employers a cushion to hold pay steady when going through a downturn. In addition, for companies that have pricing power (to push inflation towards consumers of their goods and services), wages paid, in inflation-adjusted terms, can decline.
Let’s return to this key central banks’ inflation mandate. They should facilitate the functioning of a stable, yet flexible, monetary and banking system. The majority of DM central banks judge that, at an annual rate of 2% inflation, a longer run objective is achieved. The number is derived from historical evidence showing that, most of the time, economic outcomes are balanced. The experiment was conducted first. The theory followed.
As with companies, the longer a brand exists, the longer it will live into the future. Here as well, the fact that the 2% inflation target has been around for so long, the more complex and possibly irresponsible it becomes to deviate from it. Central bank confidence or credibility has to be cherished. The 2% inflation level has indeed brought price stability whilst keeping the economic system dynamic.
What pushes inflation into positive territory is the rate of debt or credit growth per capita corrected for (or minus) the rate of productivity. Essentially, increased productivity on its own is deflationary. Productivity growth reduces consumer or producer price indices, as it requires less energy (capital and labour) through time to produce an item or service. That efficiency gain can result in lower price setting when competition is present. If we define a long-term productivity growth rate of 1% to 2% as healthy, we should expect, at the margin, a per capita credit growth of 1% to 2% per year to establish 0% inflation. Achieving a 2% inflation target thus requires a 3% to 4% per capita credit growth rate. That can only be established if consumers and corporates keep their faith in the banking system and deposit their cash in order to allow for credit growth to flourish (the essence behind the fractal banking concept).
Sound (3% to 4%) aggregate debt growth combined with a 2% inflation rate greases the world economy conditioned on a positive productivity growth of around 1% to 2%.
There are three arguments that explain why the 2% positive inflation number provides comfort. First, it accounts for a measurement bias, informing us that a 1% to 2% inflation effectively results in about 0% inflation when considering technological innovation and demographic influences. Second, a 2% inflation number will allow central banks to set long-term nominal policy rates at a level that leaves them room and space to cut interest rates when the economic cycle turns sour. For the FED, the current long-term policy rate that achieve price stability and maximum employment sits at 2.5%. Third, the 2% inflation target will avoid the ills of deflation. Essentially, the cost of 2% deflation is far greater than the cost of 2% inflation.
Yet, each of the above three arguments does not explain why we shouldn’t use a 3% or 4% inflation target? The answer is straightforward though: It has to do with compounding effects and goes under ‘The Rule of 72’. It’s a rule of thumb that allows you to map out the impact of compounding: divide 72 by the rate of compounding (i.e., a YoY inflation rate of 2%) and you find out that prices double over a horizon of 36 years (72/2). A 3% inflation rate will see a doubling of general price levels over 24 years (72/3), at 4% it takes ‘only’ 18 years (72/4). In many European countries as well as in the US, we observe approximately 8% inflation today. If that persists, prices will double in 9 years, by the year 2031. One starts to understand the impact from a business planning perspective up to the required choices and planning for starting a family. One has to deal with the knowledge that one’s savings and investable assets, lose half their value and purchasing power in fairly short order (i.e., 18 years under a 4% YoY inflation). 36 years defines a generation, thus a 2% inflation rate rhymes better in that context.
While the impact of mainly food and energy inflation is obvious to consumers and the family budget, it is far less clear to corporates. Corporates are directly impacted through the production process as well as indirectly through the demand function for their products or services. Energy companies can profit from higher inflation. Technology companies are less energy intensive and might see limited impact. Industrial and consumer-discretionary companies feel the inflation heat and pressure on their net profit margins. However, the moment second round effects hit the salary cost base persistently all companies will feel the impact on the bottom-line. Budget rounds that, for the majority of companies, will kick-off over Q3 and Q4 might raise eyebrows. To what extent does a company consider an inflation rate of around 5% by year-end as a one-off? Or do they need to include these in their multi-year planning. And here we come back to the attractiveness of a 2% inflation assumption rather than 4%.
Several IMF papers called for an inflation target of 4%. This would leave central banks with more flexibility in setting policy rates and especially more room before hitting the zero-lower-bound policy rate. According to the IMF, negative economic consequences would be limited. Although, in theory, a 4% inflation target might be useful for governments (reducing debt levels) and central banks, it would consist of a powerful debasement for the average household, hitting the purchasing power of salaries hard. Inflation has a different meaning for people in power versus people making a living from a labour income.
Holding onto an inflation target of 2% contains the risk of falling into deflation. But, more importantly, such a target anchors inflation with success. A persistent 4%+ inflation debases money too quickly and leaves corporates exposed to difficulties in forecasting budgets, assessing projects and controlling overall business model risk. Central banks carry responsibility and have to prevent that an inflationary psychology takes hold. “Whatever it takes” might be used again in the current high inflation context but with a completely different meaning. A meaning characterised by rate hikes and the end of QE.