Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / Why Central Banks Are Raising Their Inflation Targets
Transcript
- Lucas: So a few weeks ago, the Bank of Canada wrapped up its five-year monetary policy framework review, and the headline number that came out was two point five percent. Their long-run inflation target, previously two percent, is now two point five. Luna: Right, and that wasn't a big surprise — there had been speculation for months. But it's still a pretty big deal. The last time a major central bank officially raised its target was... never, I think? Lucas: Basically never. The Reserve Bank of New Zealand pioneered inflation targeting in 1990, and ever since, the two percent target has been this almost sacred number. The Fed adopted it implicitly under Alan Greenspan and made it explicit in 2012. The ECB targets 'below but close to two percent.' So when the Bank of Canada moves to two and a half, it raises the question: is the whole regime shifting? Luna: And the Fed just started its own framework review this year. There's been chatter internally about possibly raising the target to three percent. Let's talk about why. Lucas: The core argument is about the zero lower bound. Over the past two decades, central banks have hit the floor on interest rates repeatedly — 2008, 2020, and even in 2023 when the Bank of Japan was still pinned at zero. If your inflation target is two percent, the neutral nominal rate is somewhere around two to three percent in normal times. So when a recession hits, you maybe have three hundred basis points of cutting room before you hit zero. With a three percent target, that buffer is larger — maybe four hundred or five hundred basis points. Luna: Olivier Blanchard made that case in a 2023 paper, right? He argued that three percent inflation would give central banks more policy space and that the welfare costs of moving from two to three percent are actually quite small. Lucas: Exactly. Blanchard and his coauthor, Benoit Coeuré, estimated that the net benefits were positive — you reduce the frequency and severity of hitting the zero lower bound, and the extra inflation doesn't distort economic decisions much. The Bank of Canada's own research found similar results, though they settled on two point five as a compromise. Luna: A compromise between what? Lucas: Between the old guard who see two percent as a hard-won anchor for expectations, and the newer view that the world has changed. Inflation has been persistently above target since the pandemic, and central banks have been fighting to bring it down. So moving the target now might look like admitting defeat. But the Bank of Canada argued that the structural economy has shifted — aging populations, slower productivity growth, a lower neutral rate — and the target should reflect that. Luna: Let's talk about the credibility risk. If a central bank moves its target after a period of overshooting, won't markets think they're just giving up? Lucas: That's the big fear. A central bank's main asset is its credibility. If the public believes the central bank will do whatever it takes to hit two percent, then expectations stay anchored. But if you move the goalposts to two point five, people might think, 'Well, maybe next time they'll move it to three.' And then inflation expectations become unmoored. Luna: The Bank of Canada tried to address that by framing it as a five-year review, a deliberate process, not a reaction to recent inflation. They also committed to symmetric targeting — they will fight overshoots just as hard as undershoots. But I wonder if that's enough. Lucas: The Fed's review is going to be fascinating. Chair Powell has said they'll look at the framework from top to bottom. The alternative to raising the target is to use other tools to address the zero lower bound — like average inflation targeting, which they adopted in 2020, or yield curve control, or even negative rates. But each of those has its own problems. Average inflation targeting was confusing to the public. Negative rates are politically toxic in the U.S. So raising the target might be the simplest fix. Luna: But there's a political dimension here too. Congress has never formally mandated a specific number for the Fed. If the Fed raises its target unilaterally, that could invite legislative pushback. Some Republicans have already introduced bills to audit the Fed or require a rule-based policy. Lucas: Right, and central bank independence is already under strain in many countries. In Turkey, President Erdogan forced rate cuts despite soaring inflation. In Brazil, there's been constant political pressure on the central bank. So moving the target could be seen as a political concession, even if it's economically justified. Luna: What about the ECB? Christine Lagarde has been noncommittal. The ECB just finished its own strategy review in 2021 and kept the target at two percent. But they did acknowledge that the symmetric two percent means they accept overshoots temporarily. Lucas: The ECB is in a tough spot because they have multiple countries with different inflation experiences. Germany is still scarred by the hyperinflation of the 1920s — any hint of raising the target would be met with fierce opposition. So they'll probably stay at two percent for a long time, but they might use other tools like a steeper yield curve or macroprudential policy to create space. Luna: The Bank of Japan is another case. They've been fighting deflation for thirty years, and they finally have inflation above two percent. But they've been very cautious about declaring victory. They recently ended negative rates, but they haven't raised their target. In fact, some economists argue Japan should target three percent to prevent slipping back into deflation. Lucas: If walking through the economy with us has made something click, you can support the show at buy me a coffee dot com slash fexingo. That's buy me a coffee dot com slash fexingo. It helps us stay independent and ad-free. Luna: Yeah, we really appreciate it. It keeps the lights on and lets us dig into topics like this without any sponsor pressure. Lucas: Alright, back to it. So one risk that doesn't get enough attention is what happens if multiple central banks raise their targets at different times. If the Fed raises to three percent but the ECB stays at two, the dollar could weaken significantly, which might cause imported inflation in Europe. That could force the ECB's hand. Luna: There's also the question of how markets would price inflation expectations. If the Fed signals a higher target, long-term bond yields might rise immediately because investors expect higher average inflation. That could tighten financial conditions, which is the opposite of what they want. Lucas: That's the tricky thing. Central banks would need to communicate that the higher target is a structural change, not a short-term accommodation. They'd need to show they're willing to raise rates aggressively if inflation runs above the new target. The Bank of Canada tried to do that by emphasizing their symmetric commitment. Luna: But they also had the advantage of doing it in a calm period. Canadian inflation is around two and a half percent right now, very close to the new target. They weren't trying to raise the target while inflation was at five percent. That would have been a disaster. Lucas: Timing is everything. If the Fed were to raise its target, they'd probably wait until inflation is sustainably at two percent and the economy is in a good place. Some economists think that could be as early as 2028, if the next review concludes that way. Luna: Let's talk about the alternatives. Some people argue that instead of raising the inflation target, central banks should target nominal GDP growth. That way, if the economy grows faster, inflation can be lower, and vice versa. It's more flexible. Lucas: Nominal GDP targeting has a lot of academic support — Scott Sumner, David Beckworth, and others have pushed it for years. But it's complicated to communicate. The public understands inflation because they see prices at the grocery store. Nominal GDP is an abstract concept. And central banks are very wary of anything that blurs the line between monetary and fiscal policy. Luna: Plus, you'd need to constantly estimate potential GDP, which is notoriously difficult. In real time, you might be off by a lot. The Fed's estimates of potential output have been revised significantly over the past decade. Lucas: So the path of least resistance might be a modest increase in the inflation target — two and a half, maybe three percent — combined with strong forward guidance and a commitment to symmetric targeting. That seems to be where the consensus is heading, slowly. Luna: What do you think will happen at the Fed? Will they raise it? Lucas: I think it's more likely than not that they'll eventually move to two point five percent. But it will be a long, deliberative process. They'll commission white papers, hold conferences, and probably not announce anything until late 2027 or early 2028. And they'll do it at a time when inflation is low and stable. The Bank of Canada has given them a blueprint. Luna: It's interesting — the two percent target was always somewhat arbitrary. It came from New Zealand's original target range of zero to two percent, and then other countries converged on two. So maybe it's not surprising that after thirty-five years, we're rethinking it. Lucas: The world has changed. The neutral rate of interest has fallen globally, so the buffer against the zero lower bound is smaller. Aging populations mean more savings and less investment, which pushes rates down. If we don't raise the inflation target, we might find ourselves stuck in a world of frequent quantitative easing and near-zero rates, which have their own distortions. Luna: So it's really about giving central banks room to cut rates in the next recession, without having to go back to unconventional tools. Lucas: Exactly. The next recession is inevitable. And if the Fed has only two hundred basis points of room, they'll have to rely on QE, forward guidance, and maybe even negative rates. A higher inflation target gives them conventional ammunition. And conventional tools are better understood, more predictable, and less politically contentious. Luna: But they have to sell it to the public. 'We're going to let prices rise faster so that we can lower interest rates more later' — that's a tough message. Lucas: That's why communication is everything. If they frame it as 'we're modernizing our framework to better protect the economy' and they show how it benefits workers and borrowers, it could work. But if it looks like a bailout for banks or governments, it'll face backlash. Luna: Well, the next few years will tell. The Bank of Canada's experiment will be closely watched. If they can maintain credibility at two point five percent, other central banks will follow. Lucas: And if it fails — if expectations become unanchored — we'll know that two percent was more than just a number. It was a commitment.