From the WSJ:
“Why must inflation be around 2%?” is a question that obsessed central bankers back when inflation was stubbornly below their favorite target. It makes more sense to ask it now.
This past week, a string of data has suggested that inflation is finally on a downward trend. The U.S. personal-consumption expenditures price index excluding food and energy—the Federal Reserve’s preferred measure of inflation—recorded its second-smallest monthly increase for the year, even as consumer spending jumped and job growth continued. Meanwhile, eurozone inflation receded to 10% in November, suggesting that October’s 10.6% was the peak.
Stocks have rallied, especially after Fed Chairman Jerome Powell said Wednesday that interest rates will go up in smaller increments from now on. But he also indicated that the tightening is far from over. Indeed, central bankers don’t ultimately care if inflation stops rising: They want it to go down, back to the 2% number they are mandated to hit.
It underscores the misalignment between their interests and everybody else’s, which should worry investors.
Inflation in many rich countries has been decelerating since July, yet economists don’t expect it to return to 2% until a distant 2025, based on median forecasts. Derivatives markets price in that the Fed, the European Central Bank and the Bank of England will stop raising rates in 2023, cut them later in the year, and then sit on their laurels for two full years as inflation grinds down.
But what if inflation stabilizes at a higher rate—say between 4% and 6%? In this plausible case, central banks may be compelled to start needlessly raising rates again, catching investors off guard. It would make a lot more sense to raise the inflation target instead, or define it as a wider range.