News

2% - Time For A Rethink?
Tuesday 21st May 2024
Markets
After a short breather in April, stock markets have indeed started to rise again. In the US this is supported by a strong economy, a good first quarter for Company earnings results, and a continued belief that the interest rate cycle has peaked.
As we write the US S&P 500 index has achieved another all-time high at 5,317. US shares were able to break fresh ground because of encouraging inflation numbers published last Wednesday. April's Consumer Price Index (CPI) report showed a 3.4% increase on the year before, exactly in line with economists' expectations. Not particularly outstanding, you might think, compared to the EU and UK, which are fast heading down towards the 2% target. But it meant slower inflation than the month before for the first time this year, and the first time this year that US inflation did not exceed forecasts. With the inflation outlook finally improving, investors piled into US shares.
May has also brought weak employment data in the form of lower than expected growth in both hiring and pay. The silver lining here is that this is exactly what the Federal Reserve wants to see in order to cut interest rates. That's because weaker growth reduces inflationary pressure. Lower inflation numbers increase the likelihood of an interest rate cut from the US Federal Reserve, which would support higher share prices and offer relief to borrowers. Markets have been excited about the prospect of interest rate cuts since November last year, but continued strength in the world's largest economy has repeatedly pushed back the timeline. However, the Federal Reserve keeps hinting that cuts will come despite inflation still comfortably above the official 2% target.
By contrast, rate cuts look a sure thing in Europe and the UK. Inflation has come down significantly this side of the Atlantic, and this is ultimately related to weaker growth prospects. The European Central Bank (ECB) and the Bank of England (BoE) both have greater room to cut rates and more of a need to do so. While rate cuts seem certain, how deep or fast those cuts will be is still an open question. On Friday, ECB Executive Board member Isabel Schnabel warned that back-to-back cuts are unlikely. Most people think the ECB will slash rates at its meeting next month, but Schnabel thinks "a rate cut in July does not seem warranted". Policy is likely to loosen, but Europe still has its own inflation pressures and we are not about to enter a full blown easing cycle.
The UK is in a similar situation, indeed Governor Bailey said he is "optimistic that things are moving in the right direction" but needs to "see more evidence" of falling inflation before cutting the base rate leading to implied market expectations suggesting the BoE will deliver a first cut in August, and these expectations are aiding what is currently a strong period for UK equities.
Inflation target at 2% - time for a rethink?
Nearly 60 countries around the world try to keep annual price rises at this level, but few of them can explain why! In the past few months, there have been articles in the Financial Times, Bloomberg and the Guardian calling on central bankers to abandon the 2% target. Back in October, the UN's Conference on Trade and Development issued a report that included a recommendation to relax the target.
The 2% inflation target stems from an offhand comment made in 1988 by New Zealand's then finance minister, Roger Douglas. After a long period of higher inflation, Douglas told the media that he wanted inflation between zero and 1%. New Zealand's central bank had to reply, and after looking at their own figures said that 2% was more appropriate. Making the 2% target official seemed to work, and Canada adopted it a few years later.
The Bank of England (BoE) targeted 1-4% inflation after Britain left the European Exchange Rate Mechanism in 1992, which eventually became 2% after the BoE was made independent. The target is now official, set externally by the Government, with the BoE Governor obliged to write to the Chancellor with an explanation if inflation is more than 1% over or under target. To this day, the only explanation the BoE offers for why the target is 2% is that the Government says so.
The Fed's history of inflation targeting is more complicated. The Fed's Federal Open Market Committee has long agreed that there should be an inflation target, but could not agree on what the target should be. In his typical style, long-time Fed chair Alan Greenspan swore his committee members to secrecy on the matter, and it was not until 2012 that then-chair Ben Bernanke made 2% official.
There is evidence that having an inflation target helps stabilise inflation expectations, thereby encouraging price stability, but there is very little evidence for 2% specifically. The post Covid pandemic US economy, for example, has been surprisingly strong and resilient. This has resulted in higher inflation, but without much threat to price stability. The chief economist of the International Monetary Fund, Olivier Blanchard, thinks that 3-4% is more appropriate.
Of course central banks have been criticised for being slow to react to the inflation pressures building in 2022, leading to such dramatic interest rate rises in 2023 as they played catch up. Having already been criticised for being 'behind the curve' on inflation, giving up on their 2% target now might look like an admission of failure. There is no particular reason for inflation targets to be set at 2%, but given they are, and potential loss of face, any change will almost certainly wait until inflation is definitively beaten.
We leave you with a quote from Anne Frank:
"How wonderful it is that nobody need wait a single moment before starting to improve the world."