op_blejer1_Chip SomodevillaGetty Images_fed Chip Somodevilla/Getty Images

Central Banks’ 2% Inflation Target Is Not the Finish Line

When firms and workers pay close attention to inflation, they adjust their own price and wage demands more frequently – a response that can perpetuate inflation across the economy. Given this, reaching central banks’ 2% target is not enough; policymakers need to get the economy to a place where agents forget about inflation altogether.

BRUSSELS/MILAN – Sentiment in financial markets has undergone a sharp reversal in early 2024. After more than a year of aggressive interest-rate hikes by the US Federal Reserve and the European Central Bank, talk has turned to the question of when – not if – central banks will lower rates. After all, inflation in the United States and the eurozone has fallen almost as quickly as it rose, and is now near central banks’ 2% target.

To determine whether inflation has, in fact, been vanquished, we must first understand why it increased in the first place. The explanation might seem obvious. Everybody “knows” that inflation surged in 2022-23 due to external factors, especially supply-chain disruptions and energy-price increases caused largely by the COVID-19 pandemic and the Ukraine war. But even a cursory glance at the data reveals flaws in this explanation.

The energy and supply shocks to which inflation is often attributed were short-lived. Crude-oil prices fell back to pre-Ukraine war levels after just a few months, and the supply shortages that characterized the immediate post-pandemic era disappeared over the course of 2023. If these shocks were all that was going on, prices would have increased sharply, then quickly declined, with negative inflation rates taking hold.