Why Monetary Policy Institutions’ Inflation Targets Are Wide of the Mark

Can monetary policymakers hit a bullseye? Financial commentators we follow seem to want to find out, since the latest batch of transatlantic inflation data suggest America’s Federal Reserve (Fed) and the European Central Bank (ECB) are both nearing their inflation targets.^[i] But we have seen commentary claiming prices’ slowing improvement is a sign more action is needed to hit the marks. In our view, this vastly overrates monetary policymakers’ powers and ability to fine-tune outcomes, and the talk is fuelling another round of what we consider feckless forecasting of unknowable actions.

As for those aforementioned price figures, America’s April personal consumption expenditures (PCE) price index rose 2.7% y/y, unchanged from March’s rate.^[ii] Meanwhile, the eurozone’s May harmonised index of consumer prices (HICP) accelerated to 2.6% y/y from April’s 2.4%.^[iii] Both measures have been in the range of 2.4% - 2.9% since October 2023, which is fairly close to the Fed and ECB’s inflation targets of 2% y/y.^[iv]

The latest numbers are in line with inflation’s overall easing in America and Europe.^[v] But we have seen some arguments that prices’ slow cooling means monetary policy officials must act to get even closer to 2%. A former New York Federal Reserve president argued the Fed needs to do more to fight inflation since its monetary policy has yet to dampen US economic strength.^[vi] Meanwhile, the ECB’s chief economist warned inflation would get stuck above the bank’s target if Frankfurt didn’t keep rates elevated.^[vii]

We disagree monetary policy institutions need to do more. Why? For one, their targets aren’t clearly defined, in our view. Yes, yes, the ECB and Fed clearly state on their websites their target is 2% and all that. The former monitors change in the HICP over the medium term whilst the latter tracks the PCE price index over the longer run. But the ECB doesn’t define what the medium term is. The next six months? Year? Longer?

Similarly, the Fed doesn’t detail what inflation that averages 2% over the longer run means. The Fed doesn’t specify a timeframe for annual inflation to average 2%, so you can’t calculate an average. That vagueness means monetary policymakers could claim success whenever the numbers work in their favour.

Note, too, the Richmond Fed (based in Richmond, Virginia) wrote in an October 2023 blog post that Fed policymakers “did not define the window of time over which it would be looking back to assess progress toward its goal.”^[viii] We think this raises the question: What exactly are monetary policymakers aiming for today—inflation that is above, at or below the goal? Just in the neighbourhood? We don’t think anyone knows the answer, which, to us, highlights the folly in trying to foretell monetary policy institutions’ moves.

According to our research, there also isn’t any evidence monetary policymakers can fine tune inflation rates down to the decimal. The Fed made its 2% target official in 2012 and didn’t have much success hitting it. (Exhibit 1) This, in our view, explains why the Fed ditched a clearer 2% target in favour of that undefined average in 2020.

Exhibit 1: US PCE Since 2012

Source: FactSet, as of 3/6/2024.

It was a similar story with the ECB. Since 2003, the bank’s inflation rate target was “below but close to 2%” before explicitly aiming for “2% inflation over the medium term” in 2021.^[ix] Yet eurozone inflation spent most of the past two decades either above—or well below—that threshold. (Exhibit 2)

Exhibit 2: Eurozone HICP Since 2003

Source: FactSet, as of 3/6/2024.

With many monitoring the ECB’s meeting this week—and the Fed’s next week—expect plenty more speculation and discussion about what monetary policy institutions should and shouldn’t do. But we don’t think investors benefit by looking too much into these actions. Monetary policy is a blunt tool that hits at an undetermined lag, based on our studies, and we haven’t found any evidence monetary policy institutions can or should even try to slice and dice inflation rates down to the decimal.