The Monetary Theory Driving Inflation Targeting

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• Despite their different underlying economic conditions, central banks around the world have largely kept similar monetary policies anchored on inflation targeting.
• According to economist Adam Posen, the public often carries negative misconceptions about inflation data, leading to investor overreactions on central bank communications. The Federal Reserve especially must work to set and manage realistic expectations.
• Regardless of who wins the 2024 election, the American political climate is poised to keep inflation above the target rate for at least the next five to ten years.

Since the COVID-19 pandemic, nearly every major global economy has followed a similar monetary policy. First, interest rates plummeted to stimulate the shell-shocked economy, then central banks reversed course to address the subsequent inflation.

While 2024 has been a year of speculation on Federal Reserve rate cuts — and a growing chorus to expect “higher-for-longer” interest rates as the U.S. economy has remained stubbornly resilient to the pressures of inflation, there’s a larger macroeconomic mystery that isn’t getting much attention.

With the notable exception of Japan, central banks around the world have kept interest rates elevated since early 2022. Intriguingly, however, these major economic areas — the U.S., the European Union, the U.K. and Brazil among others — have significant differences in energy supply, labor markets, proximity to conflict zones and other factors that one might predict would create differences in monetary policy. What’s driving this almost singular narrative of central bank decisions?

This is the question Adam Posen recently asked in an opinion piece for the Financial Times. Adam is President of the Peterson Institute for International Economics, a nonpartisan global think tank, and his long career includes numerous consulting positions for the Federal Reserve, Bank of England and other government agencies.

In 1998, Adam co-authored “Inflation Targeting: Lessons from the International Experience.” This book was an early case study on the efficacy of inflation targeting — that is, a central bank’s transparent commitment to bring inflation to a specified rate. Somewhat to Adam’s surprise, this theory mapped out almost three decades ago is an accurate descriptor for current central bank behavior.

“If you have a credible long-term anchor for expectations with an independent central bank acting transparently, you can ease [inflation] in the short term,” Adam says.

Host Alan Dunne recently spoke with Adam on a Global Macro edition of Top Traders Unplugged to ask more about the underlying factors informing expectations around central bank decisions and the political conditions that could influence monetary policy decisions in the next few years. Read on for the key findings — and advice on how investors should move in response to central bank communication.

The mystery of central bank conformity

In many ways, Adam argues, the near-uniformity of central bank positioning on inflation should come as a surprise to economists.

“There’s a huge difference in energy consumption and energy market structure in the U.S. versus Europe versus the U.K.,” Adam says. Parts of Europe have much larger exposure to imported food and imported energy when compared to the U.S., while the labor market in Central and Eastern Europe has considerably lower costs when compared to Western Europe, the U.S. and Canada. Of course, there are also differences in demographics, political systems and proximity to the ongoing conflict in Ukraine.

And yet, dozens of nations all hiked interest rates in 2022, and, in the first half of 2024, the European Central Bank (ECB) and Canada were among the many financial institutions to announce rate cuts, almost as if there were a global playbook that everyone’s following.

“The fact that such different economic structures didn’t have differing effects [on interest rates] needs an explanation,” Adam says. “Otherwise, there’s nothing that’s similar across countries.”

The only common thread is a policy response to inflation.

So what exactly is that policy? More than just a numerical response to consumer prices and employment data, Adam sees a concerted effort for central banks to set and uphold public expectations. This is the idea of a target inflation rate, which for the ECB, U.S., U.K., Brazil and many other nations stands between 2% and 3%. If inflation remains above the target, central banks will tighten, while if inflation nears the target, interest rates will drop. Critically, for this system to work, central banks have to be transparent.

Managing expectations

Speaking about high-income economies in particular, Adam describes the public view of inflation as asymmetric. “[Most people] hate overshooting inflation more than they hate undershooting,” he explains.

For instance, it’s well documented that, over the last year especially, most Americans have negative misconceptions about the economy, such as believing the economy is shrinking while actually GDP is growing. Above-target inflation, then, likely sounds worse to the general public than it does to economists or investors.

Unfortunately for central banks, most forecasters see inflationary headwinds in the next decade. “For climate reasons and geopolitical reasons, we should expect there’s going to be more energy and food price shocks, more wars, sadly, and more migration,” Adam says. So central banks are between a rock and a hard place — the public hates high inflation, but a 2% target seems unattainable for the foreseeable future.

Even if some members of the Fed might think 3% or even 4% is a more realistic inflation target, moving the goalposts now risks a major hit to their credibility. “Announcing inflation targets is kind of like announcing an exchange rate peg. Once you announce it, it’s very hard to change,” Adam explains.

The result is what has become these highly dramatized news conferences where Jerome Powell, Chair of the Federal Reserve, tries to offer guidance while preventing an overreaction in the markets. He strikes a balance between reminding that the U.S. hasn’t reached the 2% inflation target while maintaining enough positivity to avoid a backlash. “Whenever [Powell] makes a statement, he’s correcting to the dovish, or the hawkish side from what his last statement was,” Adam notes.

But is it misleading to put so much emphasis on the nominal interest rate? Some critics of inflation targeting say that is.

More than just numbers

Economists look not just at the established Fed funds rate but also the real interest rate — one adjusted for inflation. For example, if the interest rate on a deposit is 4% but inflation is 3%, the actual return on investment is only a 1% gain in purchasing power.

Alan asks, “Which of these is more important — nominal [interest] rates, real rates, financial conditions or changes in the rates?”

For Adam, financial conditions are an easy winner. As discussed, the Fed’s changes to the nominal rate aren’t necessarily tied to the impact of inflation, and “the real rate of interest is not a sufficient statistic for credit conditions,” he explains. Bond credit spreads, international capital flows and even consumer savings behavior all impact the lending process.

As an example, Adam points to the 2023 collapse of Silicon Valley Bank (SVB) as the result of poor regulation and supervision, not as something tied to inflation or interest rates. In other words, the financial conditions driving tech startups to make heavy withdrawals — combined with SVB’s failure to properly manage its deposits and hedge against interest rates risk — were to blame, not the central bank’s monetary policy.

The takeaway? Adam advises investors to be wary of market overreactions to any interest-rate announcements from the Fed.

“If there is a large move due to a [Federal Reserve] statement, I would take the other side of that bet,” Adam says.

Observations of the US economy

After more than a year of holding interest rates steady, the Federal Reserve has signaled that it won’t wait until reaching the target of 2% inflation before cutting rates. How should investors understand the current state of the U.S. economy? Adam offers four observations.

1. Prepare for a soft landing

Powell’s comments show that the central bank may be responding to public pressure. Instead of holding the line until inflation comes down closer to the target rate, the Fed may look to keep pace with other nations that have already started to lower the cost of borrowing.

“The Fed is not as tight as they think they are,” Adam says. “I don’t expect any sharp downturn.” In other words, one way to look at the sustained inflation in recent months is to say the Federal Reserve isn’t putting enough pressure on the economy to dampen the market. The so-called soft landing that avoids a recession is increasingly possible, especially if a small downtick of the Fed funds rate reignites business spending.

2. Expect congressional spending

No matter the outcome of the 2024 presidential election, Adam predicts Congress will continue to stimulate the U.S. economy in 2025 — at least more so than where most baseline expectations sit right now.

“There’s going to be defense spending, infrastructure spending, industrial policy spending, irrespective of what happens [in the election],” Adam says. Government spending could be another factor helping the U.S. avoid recession, and potentially a factor keeping inflation above the target rate.

3. Watch for a productivity jump

In 1996, before the internet had taken hold of everyday life, then-Fed Chairman Alan Greenspan predicted the information technology boom would drastically increase economic productivity. Now, in the age of artificial intelligence and machine learning, we could be looking at another productivity jump in the next several years.

Adam sees labor hoarding and heavy investment into AI technologies as two indicators that a positive productivity shift is coming, “probably in less than five years.” A corresponding surge in economic output is another reason the U.S. is likely to sidestep a recession.

4. Get ready for stagflation politics

Finally, no matter who takes the White House in 2024, Adam expects policy-making to slow economic growth and raise prices for Americans.

Anti-trade policies — as both Democratic leaders and Donald Trump have campaigned to be tough on China — will likely have an inflationary effect as tariffs pass higher costs onto consumers. Meanwhile, “anti-migration policies, including deportations, are going to be contractionary,” Adam adds. The combination of higher prices and slow economic growth is known as stagflation.

Monitoring political impacts

Speaking of politics, Adam views far-reaching nationalist policies as the biggest threat to central bank independence. “If there is a fiscal crisis in the next few years,” he says, “it is likely going to be completely due to political breakdown in the U.S., not due to market forces.”

But thinking optimistically that Congress can continue to function — growing peacetime, non-pandemic deficits will keep high interest rates on U.S. bonds. If China, historically one of the largest holders of U.S. Treasuries, slows its bond purchases, there could be even more upward pressure on rates.

“We potentially end up with a world that further increases U.S. interest rates because there’s just simply a smaller supply of savings to fund a larger supply of Treasuries,” Adam explains.

Think contrarian

So we’re left with a familiar paradox. The public has no patience for inflation, and it behooves the Federal Reserve to speak in terms of meeting a target, even if all other economic factors indicate that goal is entirely unrealistic in the next few years. The Fed is clearly feeling some pressure to announce rate cuts in the coming months, but Adam sees sustained high rates as the more likely macro-narrative. If other investors are prone to overreact at the next Fed press conference, perhaps it’s wise to look the opposite way.

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This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.