Best of the Week
Most Popular
1. TESLA! Cathy Wood ARK Funds Bubble BURSTS! - 12th May 21
2.Stock Market Entering Early Summer Correction Trend Forecast - 10th May 21
3.GOLD GDX, HUI Stocks - Will Paradise Turn into a Dystopia? - 11th May 21
4.Crypto Bubble Bursts! Nicehash Suspends Coinbase Withdrawals, Bitcoin, Ethereum Bear Market Begins - 16th May 21
5.Crypto Bubble BURSTS! BTC, ETH, XRP CRASH! NiceHash Seizes Funds on Account Halting ALL Withdrawals! - 19th May 21
6.Cathy Wood Ark Invest Funds Bubble BURSTS! ARKK, ARKG, Tesla Entering Severe Bear Market - 13th May 21
7.Stock Market - Should You Be In Cash Right Now? - 17th May 21
8.Gold to Benefit from Mounting US Debt Pile - 14th May 21
9.Coronavius Covid-19 in Italy in August 2019! - 13th May 21
10.How to Invest in HIGH RISK Tech Stocks for 2021 and Beyond - Part 2 of 2 - 18th May 21
Last 7 days
The US Dollar is the Driver of the Gold & Silver Sectors - 28th Jul 21
Fed: Murderer of Markets and the Middle Class - 28th Jul 21
Gold And Silver – Which Will Have An Explosive Price Rally And Which Will Have A Sustained One? - 28th Jul 21
I Guess The Stock Market Does Not Fear Covid - So Should You? - 28th Jul 21
Eight Do’s and Don’ts For Options Traders - 28th Jul 21
Chasing Value in Unloved by Markets Small Cap Biotech Stocks for the Long-run - 27th Jul 21
Inflation Pressures Persist Despite Biden Propaganda - 27th Jul 21
Gold Investors Wavering - 27th Jul 21
Bogdance - How Binance Scams Futures Traders With Fake Bitcoin Prices to Run Limits and Margin Calls - 27th Jul 21
SPX Going for the Major Stock Market Top? - 27th Jul 21
What Is HND and How It Will Help Your Career Growth? - 27th Jul 21
5 Mobile Apps Day Traders Should Know About - 27th Jul 21
Global Stock Market Investing: Here's the Message of Consumer "Overconfidence" - 25th Jul 21
Gold’s Behavior in Various Parallel Inflation Universes - 25th Jul 21
Indian Delta Variant INFECTED! How infectious, Deadly, Do Vaccines Work? Avoid the PCR Test? - 25th Jul 21
Bitcoin Stock to Flow Model to Infinity and Beyond Price Forecasts - 25th Jul 21
Bitcoin Black Swan - GOOGLE! - 24th Jul 21
Stock Market Stalling Signs? Taking a Look Under the Hood of US Equities - 24th Jul 21
Biden’s Dangerous Inflation Denials - 24th Jul 21
How does CFD trading work - 24th Jul 21
Junior Gold Miners: New Yearly Lows! Will We See a Further Drop? - 23rd Jul 21
Best Forex Strategy for Consistent Profits - 23rd Jul 21
Popular Forex Brokers That You Might Want to Check Out - 22nd Jul 21
Bitcoin Black Swan - Will Crypto Currencies Get Banned? - 22nd Jul 21
Bitcoin Price Enters Stage #4 Excess Phase Peak Breakdown – Where To Next? - 22nd Jul 21
Powell Gave Congress Dovish Signs. Will It Help Gold Price? - 22nd Jul 21
What’s Next For Gold Is Always About The US Dollar - 22nd Jul 21
URGENT! ALL Windows 10 Users Must Do this NOW! Windows Image Backup Before it is Too Late! - 22nd Jul 21
Bitcoin Price CRASH, How to SELL BTC at $40k! Real Analysis vs Shill Coin Pumper's and Clueless Newbs - 21st Jul 21
Emotional Stock Traders React To Recent Market Rotation – Are You Ready For What’s Next? - 21st Jul 21
Killing Driveway Weeds FAST with a Pressure Washer - 8 months Later - Did it work?- Block Paving Weeds - 21st Jul 21
Post-Covid Stimulus Payouts & The US Fed Push Global Investors Deeper Into US Value Bubble - 21st Jul 21
What is Social Trading - 21st Jul 21
Would Transparency Help Crypto? - 21st Jul 21
AI Predicts US Tech Stocks Price Valuations Three Years Ahead (ASVF) - 20th Jul 21
Gold Asks: Has Inflation Already Peaked? - 20th Jul 21
FREE PASS to Analysis and Trend forecasts of 50+ Global Markets by Elliott Wave International - 20th Jul 21
Nissan to Create 1000s of jobs with electric vehicle investment in UK - 20th Jul 21
Bitcoin Halvings Price Forecast and Stock to Flow Analysis - 18th Jul 21
Dell S3220DGF Unboxing and Stand Assembly - 32 Inch 165hz Curved Gaming Monitor Amazon Discount - 18th Jul 21
What Does The Fed Mean By “Transitory Inflation” And Why Is It Important To Understand? - 18th Jul 21
Will the US stock market’s worsening breadth matter? - 18th Jul 21
Bitcoin Halving's Price Projection Forecasts Trend Trajectory - 18th Jul 21

Market Oracle FREE Newsletter

How to Protect your Wealth by Investing in AI Tech Stocks

2 %: A Magic Number or an Obsession?

Economics / Inflation Oct 30, 2019 - 02:05 PM GMT

By: Submissions

Economics

Arf Badeckandy writes: Inflation Targeting (IT) was first adopted in New Zealand in 1990 with a primary goal of price stability. They were going through years of high inflation and slow growth. Initially, they set a target of between 0 to 2 percent. In 1991, the Inflation rate was down to 2.60% from 6.10%. Although there is a cost of disinflation and the Real GDP fell, it recovered. As of August 2019, there are about 71 Central Banks which has adopted an IT Monetary Policy. It can be seen that the authorities are most likely to adopt this policy when their inflation rate is high – to bring it down. Argentina adopted IT in 2016 while the inflation rate was 35.5%, Uganda in 2011 with an inflation rate between 16%-17 %.


The anchor that the policymakers use to control the price levels in an economy evolved from currency peg to floating exchange rate to inflation targeting. IT gets an edge over the other montery policy frameworks as its easy to communicate the target and be understood by the public. It puts the Central Bank in the limelight, making them more accountable which results in an increased public confidence. Over the last 3 decades, IT has helped economies control extreme volatility of inflation and large price fluctuations for oil & commodities.

How does it work?

The Central Bank forecasts the inflation rate and compares it with the rate deemed appropriate for the economy by the fiscal policymakers. If the target is not sufficiently credible, the policymakers have the instrument of Interest Rate Policy to adjust the difference. When this forecasted rate is higher than the target, to suppress the growth(disinflation), policymakers may increase the nominal interest rate. One could argue that this could be biased towards one group. The interest income earners get better off at the cost of the lender and vice-versa in a low inflation forecast. On the contrary, Central Banks are willing to accept a recession(lower output than natural) in the short term if they deem the inflation in the economy is above the target. IT is set for a specific timeframe and the Central Banks try to keep the inflation close to this target on average. Meeting this target every quarter isn’t feasible and volatility isn’t very concerning unless the rates have been consistently over or below the target.

James Bullard, St. Louis Fed explains why setting an inflation target is important as “Firms and households take into account the expected rate of inflation when making economic decisions, such as wage contract negotiations or firms’ pricing decisions. All of these decisions, in turn, feed into the actual rate of increase in prices”. Hence, there should be transparency in informing the IT to the market and there should be credibility in maintaining it over the time horizon – to help make businesses and households planning more conducive.

The 2% standard

Most countries have a low single-digit IT. A target of 2% is seen as an ideal rate for price stability.It should mean that the price level should double in about 36-37 years. When true price stability is the target, ideally the rate should be 0, but Reifschneider and Williams in their paper on setting inflation target provides support for what should be a 1% cushion in a very low inflation environments, and 1% is generally added as a measurement error. 2% sort of became an international standard from the ’90s since the Fed began planning around it. The US has been averaging a 2% since 1995, but only announced this as a target in 2012.  European Central Bank targets a below or close to 2% over the medium term. Bank Of England has historically kept the rate at 2%.

Most economies target a positive IT and not zero or minus as a positive IT drives individuals and businesses to make advance purchases, and should hence boost output and economic growth. Also, a higher inflation rate would mean higher interest rates. This gives Central Banks enough room to cut rates upon recession (contraction in output for 2 consecutive quarters or more). While a low-interest rate is expected to result in increased borrowing and spending, hence boost economic growth, the Neo-Fisherian theory suggests that a low Monetary Policy Rate could result in low inflation, as the inflation expectation would fall once the interest rate is set low. Also, when there is a suppressed interest rate the low performing or barely profitable businesses get access to cheap capital and this doesn’t always result in better growth, rather an opposite effect leading to potential bad loans, symptoms of an impending debt crisis.

Another reason often cited is to avoid deflation. When deflation happens, the asset prices decline - which may be followed by a debt crisis. Furthermore, there will be a delay in consumption and investment as people forecasts further price falls. The cost of a negative movement of prices in an economy would be far higher than the cost of positive movement.

Shortcomings of a low target rate

It is widely known that the 2% target the economies around the world sees as the magic number has no theoretical justification. Although there is no one size fits for all, the 2% is highly debatable for some of the economies considering how there is little room for rate cuts during a recession since nominal interest rates shouldn’t ideally be zero. With a low interest rate, increased money supply should ideally generate inflation as more money is chasing the same quantity of goods, but once the nominal interest rate hits zero the opportunity cost of holding cash is also zero and the increased money supply in the economy translates to more savings and not spending. When the inflation is maintained very low or between 0 to 2, there’s a risk of falling into the negatives (deflation). The case for a higher IT is that it allows further decreases in interest rates until zero. A higher target could have prevented interest rates from hitting the zeros during the Great Recession. And could prevent the same in the future recessions.

Alternative

According to the IMF, a global recessions may occur over a cycle which lasts between 8 to 10 years. To create enough room for interest cuts during that recession, the IT could be raised to a 3% or even a 4%. There are obviously costs, but not as much as one would incur in lost output and employment if the rates has to go to zero. If the calculation is wrong, the economy could end up with a marginally higher inflation, but if proved right, the economy is left with enough cushion to respond to the recession.

By Arf Badeckandy

Bio: Arf Badeckandy is an EY Alum and an MBA candidate at Great Lakes Institute of Management.

© 2019 Copyright Arf Badeckandy - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in