Why central banks should overhaul inflation targets instead of ditching them as economic shocks intensify

If a crucial goal of central banks is controlling inflation, then targets for the pace of price changes have been an indispensable ally. To rise to the task of helping economies with the challenges of the 21st century, their usefulness needs a rethink.

This isn’t simply a question of raising or lowering them, but whether they can be adapted to a very different world to the one in which they were born. Monetary authorities are navigating a rapidly changing and unpredictable landscape.

They can easily be thrown off track by upheavals in global distribution networks, political shocks, public-health emergencies, and the reshaping of the workforce and spending habits by AI.

This will result in faster inflation or the opposite — deflation. Targets will be missed more frequently. The big disruptions of the past two decades — the global financial crisis and the pandemic — may have just been a foretaste.

It behooves monetary chiefs — already in the crosshairs of lawmakers — to articulate more clearly not just what prices will do under their main assumptions, but what alternative scenarios might look like.

The tension between how much to tighten or ease rates to meet a target — around 2 per cent for most central banks is not new, but it’s likely to intensify.

As one US Federal Reserve governor noted during a 2007 debate on targets, officials shouldn’t beat businesses and consumers “over the head with a baseball bat.” It would be another five years before the US rolled out its own objectives to achieve price stability.

Inflation targets have successfully steered the global economy because they have helped keep inflation expectations among businesses and consumers in developed countries well-anchored.

From beginnings in New Zealand, formal objectives have been widely adopted by central banks including the European Central Bank (ECB), the Bank of Japan, Bank Indonesia and the South African Reserve Bank. Scrapping them would be a serious error. In the absence of a better alternative, economies would fly blind because policy becomes untethered. They offer a reference point, just as the gold standard and government-managed foreign-exchange rates did in previous generations.

They do require work if they are to survive. Some major markets, including the US and UK, are suffering price gains that have been marginally above the threshold for years. In the euro zone, the clip has climbed notably since the Iran war began and is just below three per cent.

By restricting inflation to small amounts each year, an economy can grow on a sustainable basis. But how can central banks assure people that it won’t become a problem? There must be a system, with at least some firmly established rules, and it must be easily understood. Credible communication is vital.

Massachusetts Institute of Technology Professor Kristin Forbes suggests one very useful enhancement: providing a fairly clear time frame for restoring inflation to target in the event of a prolonged miss.

The Bank of England (BOE) has signalled a readiness to return to 2 per cent over three years. The Reserve Bank of Australia stressed that an uber-aggressive series of hikes might return price increases to the objective rapidly but at the cost of low unemployment.

More authorities should consider articulating a gradual but succinct horizon. “You don’t want to be responsible for hitting a target each month when a global shock will veer you off course,” Forbes, a former BOE rate setter, told me. “It’s about the direction of inflation, the path.”

For that, central bankers must be extra nimble; the shocks they will encounter won’t just be domestic in nature. In addition to the traditional tasks of fine-tuning prices, staving off recessions, and responding to currency fluctuations, Jerome Powell, whose eight years at the helm of the Fed ended in May, was confronted with COVID, the resulting jump in inflation, Russia’s attack on Ukraine, the Middle East conflict, and a norm-shattering White House. Some of Mr Powell’s ordeals will present themselves again.

Rigid formulas for setting interest rates, especially inflation targets, may recede in importance.

New US Federal Reserve Chair Kevin Warsh has criticised policymakers who fixate on “two numbers to the right of the decimal point in the latest government release.” But he emphasised that the target is a long-cherished goal that shouldn’t be brushed aside before victory is clinched.

Price stability, however defined, must remain the holy grail. Few things are more detrimental to a society than the belief that the purchasing power of its citizens will deteriorate significantly each year. In the absence of income gains, inflation chips away at the ability to provide food, shelter and clothing. A little is a good thing because it suggests a vibrant economy.

Too much for too long and people may lose faith in underlying financial and political arrangements. The debasement of the Roman currency is often linked to the eclipse of that empire, while China endured hyperinflation before the communists seized power in 1949. On a less bloody scale, years of double-digit inflation undermined the UK Labour government in the late 1970s and ushered in the Thatcher era.

Today, cost-of-living pressures have regained their potency. Polls show widespread dissatisfaction with US President Donald Trump’s handling of the US economy, especially the stickiness of inflation. Rising prices also have sparked a backlash against incumbent governments in places like Australia.

How an isolated country arrived at 2 per cent as a target that would become the benchmark for other central banks was almost by accident. As inflation finally slipped below 10 per cent, New Zealand’s then-finance minister, Roger Douglas, was asked by a journalist in 1988 if he was satisfied. No way, he answered, it should be zero or between zero and 2 per cent.

“Most people at the Reserve Bank thought this was nuts,” Don Brash, the Reserve Bank NZ chief appointed shortly afterward, told me. But officials had to try to make it happen. “To the astonishment of the Reserve Bank staff, we delivered it.”

The idea had some high-profile opponents. Paul Volcker, revered for his role in smashing the double-digit US inflation of the early 1980s, considered it a fantasy that the right level could be identified so precisely. Alan Greenspan, who succeeded him, was horrified at the idea of elevating numerical targets. He fretted that he would lose discretionary power.

Even after the Federal Open Market Committee coalesced around an objective of 2 per cent in the mid-1990s, members were sworn to secrecy. Ben Bernanke, who as chair championed greater openness, ultimately went public more than a decade later.

But the targets were never intended to be ironclad. In practice, they are set largely based on forecasts — not just the latest data that might be subject to revisions. And the intention was always to have a buffer, some wiggle room to allow for rare shocks.

Tweaks have precedent. In New Zealand, the target was widened to between 1 per cent and 3 per cent over the medium term, with the half-way point seen as most desirable.

In the UK, it went from 2.5 per cent at the time of independence in 1997 to the current level of 2 per cent. And there is a safety valve: If inflation exceeds that level, the BOE governor is required to write to the Treasury explaining the deviation and undertaking a return to the target.

But too much flexibility isn’t helpful either. It will leave people wondering if the targets mean anything at all.

The trick isn’t clamping down on the free speech of policymakers, as Mr Warsh seems to favour, but in getting across the right message about the way to view these goals. It should be accompanied by explanations of the grounds for deviation, for how long, and what scenarios might play out.

Should there be less talking, as Mr Warsh recommends? Probably. But it’s hard to convey stretchiness without speaking about the likelihood of hitting the target or not.

Did the inflation-targeting banks just get lucky? During the 1990s, the oil shocks of the prior decade receded and the entry of China into the global market dramatically lowered the cost of manufactured goods. Organised labour lost much of its former power; strikes were less disruptive and wage rises were subdued.

The environment for the rest of the 21st century will be more challenging. Mr Warsh, and whoever succeeds Christine Lagarde next year at the ECB, will need all the tools available to them. Inflation targets can again prove their worth — equipped, technically and rhetorically, for the new age.

©2026 Bloomberg