Why the coronavirus crisis may prompt central bankers to scrap inflation targeting

The Federal Reserve building is pictured on Tuesday August 6, 2019.
Caroline Brehman | CQ-Roll Call Group | Getty Images

Central banking mandates could be permanently refocused away from inflation after the coronavirus crisis, economists have told CNBC.

The new coronavirus — which has infected 2.9 million people worldwide and killed more than 206,000 — is expected to spark a once-in-a-generation economic crisis, with the International Monetary Fund warning the world is soon likely to experience the worst recession since the 1930s.

Lockdown measures aimed at mitigating the spread of the virus have already led to record jobless claims in the U.S., with 26.4 million people filing for unemployment insurance in the five weeks to April 18. Job losses amid the crisis have now wiped out all of the job gains since the Great Recession.

According to Pushan Dutt, professor of Economics and Political Science at INSEAD, the economic fallout from the outbreak will prompt central bankers of the future to reshuffle their priorities.

Speaking to CNBC via telephone, he noted that a lot of today's central bankers had grown up during the oil price shocks of the 1970s.

"So they have put a lot of weight on inflation — they are much less worried about unemployment," he said. "The next generation of central bankers who take over would have grown up during the global financial crisis and the Covid-19 pandemic. These central bankers will put, in my opinion, more weight on reducing unemployment and they will worry far less about inflation," whether it's the Bank of England, the European Central Bank or the Federal Reserve.

Inflation is a measure of how much the price of goods and services have increased over time.

Many central banking systems, including the European Central Bank, U.S. Federal Reserve, Federal Bank of Australia and Bank of England, develop their monetary policy around price inflation targets, aiming to keep consumer prices rising at a stable level. 

However, Joseph Gagnon, senior fellow at the Peterson Institute for International Economics (PIIE), pointed out that a refocus toward employment was most likely to happen outside of the United States.

"For the Fed, employment has always been an equal goal to inflation — so that won't change," he said via telephone. "But I think it might change elsewhere where employment hasn't had the same status. And it should change, frankly, because I think they're actually both equally important goals for central banks."

'Not fit for purpose'

Gabriel Sterne, head of global strategy services and emerging markets macro research at Oxford Economics, agreed that the Covid-19 crisis would "almost certainly" shift focus away from price inflation targets.

"I think coronavirus will definitely have a big impact on inflation and views towards policy — I think it could tip the monetary frameworks over the edge," he said in a phone call. "Most central banks do inflation targeting, but the problem with inflation targets is that they are both too high and too low."

He explained that over the last decade, monetary policy had largely failed to deliver targeted inflation rates in many markets.

"If you have monetary policy trying to hit inflation at 2%, what we've seen is central banks just failing to do it, because they haven't got enough space on the downside," Sterne said.

"Imagine if inflation was on average 4% and interest rates on average were 4% — that would mean when you get a nasty shock, you can lower interest rates and you wouldn't get to zero and think 'oh, my goodness, we can't lower interest rates anymore,' which is where all central banks are now."

He added that inflation targets were also "too high" because central banks kept undershooting and failing to meet them.

"The point is, inflation targets just aren't fit for purpose at the moment," Sterne told CNBC, also claiming that central banks' inflation forecasts were no longer fitting for the current economic climate.

"I think the credibility of inflation targeting regimes is really low at the moment, as low as it ever has been, to the point where they're pretty redundant," he said. "Financial markets have been way better at predicting inflation than central banks are. I think the whole framework now has lower credibility internationally than it has since inflation targets were started in the early 90s."

Sterne added that he expected all central banks to miss inflation targets amid the pandemic, noting that the crisis would "absolutely" make it even more difficult for targets to be met.

U.K. inflation fell in March, data from the Office for National Statistics showed last week, with Britain's consumer price index coming in at 1.5% compared to 1.7% in February. The Bank of England aims to keep inflation at 2%.

Sterne told CNBC he expected to see a similar pattern globally as the coronavirus crisis continued.

"It's going to go lower and that will be repeated the world over — especially with oil prices going down to very low levels," he said. "We're going to see a lot of economies with very, very low, if not negative, inflation in the next year, which almost makes central bank inflation targets redundant."

Wage inflation

The idea of shifting away from price inflation targets had been floated before the Covid-19 outbreak took hold of the world.

At a Brookings Institution event in October, Olivier Blanchard, Robert Solow professor of economics emeritus at MIT, senior fellow at the PIIE and former director of the IMF's research department, suggested the Fed should instead target wage inflation, claiming it had a closer link to unemployment than price inflation.

"It clearly is much more related to labor market development … it seems like a better measure to actually look at," he said at the time. "Also politically, telling people the Fed cares about wages and has wage inflation as a target, is probably a plus."