Price stability is part of every modern central bank’s mandate. By targeting inflation, central banks make sure that their actions spur economic growth. The COVID-19 pandemic triggered bottlenecks that led to severe price increases, yet central banks expect higher inflation to be transitory.
Inflation refers to the change in the price of goods and services over a certain period. Tracked monthly and annually via different indices, inflation is part of every modern central bank’s mandate.
The inflation-targeting framework was first pioneered by the Reserve Bank of New Zealand a few decades ago. Its success in maintaining price stability enabled the model to be quickly embraced in other jurisdictions. Nowadays, all central banks target a certain inflation level, albeit a different one from case to case.
For example, the Federal Reserve in the United States sees price stability if inflation averages 2% over a certain period. Or, the European Central Bank’s definition of price stability is given by inflation reaching its target of below, but close to 2%. Finally, the Bank of Canada targets a range of 1%-3% for inflation within its mandate.
Will the monetary and fiscal stimulus in response to the COVID-19 pandemic trigger much higher inflation than the central banks’ targets? According to central banks, higher inflation should be viewed as transitory.
The Transitory Narrative Increasingly Part of Central Banks Communication
Forward guidance is crucial for central banks to properly communicate their intentions. It sets the inflation expectations, which are critical for fulfilling the mandate.
Because inflation rose the most in the last four decades in April and May this year in the United States, the Fed’s transitory narrative increased as a consequence. Moreover, other central banks followed suit.
The highest increase in inflation in the developed world is expected in the United States. Unsurprisingly, one might add, considering that the fiscal and monetary stimulus was the largest.
Yet, even in the United States, market consensus indicates that inflation will cool down by the end of 2022. If that is the case, the Fed is right in its “transitory inflation” guidance. Will markets believe the Fed’s message?