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What does the current inflationary upsurge tell us about prospects for inflation in the long run? My focus here will be on the UK. But the broad lesson may be relevant elsewhere: it is irrational to believe that central banks will hit their long-run targets. More precisely, inflation will be asymmetric, with bigger overshoots on the upside than on the downside.
Some two decades ago, I had a discussion with one of the Bank of England’s then most senior officials in which it was suggested that although the bank would rarely hit the 2 per cent target precisely, over time the errors should be symmetrical. The expected long-term outcome should be the price level implied by the 2 per cent annual target. For many decision makers, this expectation for the future price level was as important as annual inflation because it would determine the real value of a sterling-denominated contract — a conventional bond or an annuity. If it proved correct, the inflation targeting regime would give both short-term policy flexibility and long-term price-level predictability. This seemed a superb combination and a justification for inflation targeting.
The recent inflation surge forces us to ask whether it is true. It seems not.
Let us start in 2003, when the UK target was tied to the consumer price index. Since then, the actual price level has been rarely and only very slightly below the level implied by cumulative 2 per cent inflation, despite the long-term disinflationary shock of the financial crisis of 2007-09 and its aftermath. But the deviation was small. In February 2021, the price level was a mere 2 per cent higher than that implied by consistent success in achieving the target. Inflation targeting seemed to be delivering the price level stability one might have hoped for.
Since then, the story has been very different. In June of this year, the consumer price level was 17 per cent higher than the level implied by the target. This followed a 21 per cent cumulative rise in the price level over the previous three years. The UK had suffered the equivalent of almost 10 years of inflation at 2 per cent in less than a third of that time! By August, it was as if inflation had run at a compound rate of 2.8 per cent since June 2003, not at 2 per cent.
Not so long ago, many policymakers were worrying about cumulative undershoots of the target. In the US, this led to a decision to offset past undershoots in future policy. That was not then an issue for the Bank of England. But suppose past mistakes mattered. Even with zero inflation, it would take until mid-2031 before the price level would be back where 2 per cent inflation from June 2003 should have put it.
The bank is not mandated to do that. Even so, this big overshoot gives some important lessons.
What it tells us about the economy is that price levels are most unlikely to crash downwards but they can easily shoot upwards, as they have done recently and also did in the 1970s. The second lesson is that policymakers work far harder to avoid deflation than above-target inflation. This is no surprise: keeping activity up is much more popular and so easier to do than pushing unemployment upwards.
The state of the business cycle also affects the thinking of economists. There are perfectly good reasons to ask whether 2 per cent is the best target. Yet only a few argued that it should be lowered in the aftermath of the financial crisis. More recently, however, influential economists have argued for a higher target, as inflation has jumped. Furthermore, as Soumaya Keynes has noted, some economists are also pointing out that tighter monetary policy may inflict long-term economic scars. This is surely true. But it was also to be expected that people would make this argument when inflation was high.
My conclusion is that over the long run, monetary policy will be asymmetric. In recessions, central banks will loosen quickly and sharply; in inflationary booms, they will be reluctant to respond so quickly. Over the long run, then, average inflation is likely to be higher than the target.
This is why I would support the views of Catherine Mann, former chief economist of the OECD and now a member of the Monetary Policy Committee. As she argues in a thought-provoking recent speech, “I would rather err on the side of over-tightening.” The duration of high inflation matters because it increases the chances that people will doubt whether an average of 2 per cent inflation is likely in the long-term. The UK evidence already indicates that this is unlikely. A rational person would not believe otherwise.
