One of the best known of the latter category was a routine press conference in East Berlin in November 1989, when a media relations officer of the East German government was pressed about when new rules on travel restrictions to West Germany would be put in place. Uncertain of the answer, he spontaneously mumbled, “unverzüglich” – immediately. Within hours, border posts were overrun with tens of thousands of people flooding to West Berlin. The Wall had collapsed and the Cold War was over. 

Another such moment happened the same year in the unlikely setting of Wellington, New Zealand. In a similarly routine press conference, finance minister Roger Douglas was asked what he considered to be the ideal inflation rate, given that the Reserve Bank was soon to be made independent and given the world’s first inflation targeting mandate. Also entirely unsure of the answer, he mumbled, “zero to 2% seems to be appropriate”.

“It was almost a chance remark,” the then head of the Reserve Bank of New Zealand, ex-farmer Don Brash, said in a recent interview. 

“The figure was plucked out of thin air to influence the public’s expectations.”

This story has since become the stuff of monetary policy legend. The experiment of an independent central bank with a 0% to 2% inflation target was so successful in slaying the high inflation of the 1970s and 1980s, that almost all of the world’s most advanced nations subsequently emulated it in one form or another (including the South African Reserve Bank, even if its target range is wider, at 3%-6%). 

For the world’s most important central banks, a 2% inflation target is virtually a monetary policy religion. 

“Let me be quite clear, there are no ifs or buts in our commitment to the 2% target. That’s our job, and that is what we will do,” said Bank of England governor Andrew Bailey last July. 

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President of the ECB Christine Lagarde concurred last week in a panel discussion during the World Economic Forum: “We shall stay the course until … we can return inflation to 2%.”

Yet in hindsight, the 1990s and 2000s were easy periods in which to be a central banker with an inflation target. The world enjoyed 30 years where globalisation brought cheap goods, cheap energy, cheap labour and cheap capital. 

Cheap goods came from China’s mercantilist policies; cheap labour came as globalisation brought two billion people into the labour force, holding down developed world wages. Cheap energy came from Opec and Russia.

However, the geopolitical and macroeconomic landscape has experienced a tectonic shift in the last two years. 

“Globalisation is dead and free trade is almost dead. A lot of people wish they would come back, but I don’t think they will,” says Morris Chang, the founder of chip manufacturing leviathan, the Taiwan Semiconductor Manufacturing Company. 

What were secular tailwinds for lower inflation have turned into headwinds. 

Therefore, as markets and economists grapple with the paths of inflation, interest rates and growth over the next 12 months, much will come down to how stubborn inflation turns out to be above this 2% level. 

Inflation is moderating – but it is not plummeting. 

The critical moment of 2023 will come if inflation flatlines at 4%-6% but remains elevated above target range. At this point, will central banks decide to jettison three decades of meticulously crafted credibility and widen the target, risking permanently higher inflation? Or do they stick to their guns and risk plunging the global economy into a recession? 

In 1990s New Zealand, it took an unemployment rate of 11% in order to get inflation to below 2%. Why would inflation pressures, so broad based as we enter 2023, suddenly dissipate? And even if they do, would that not be because a recession has driven up unemployment meaningfully? 

How quickly can a Fed, so concerned about being the one that let the inflation genie out of the bottle, realistically reverse course?

It remains to be seen whether Jerome Powell, Christine Lagarde and their central banking colleagues are as wedded to the 2% inflation target as their erstwhile 1990s predecessors. 

The current monetary context is very different and considerably more challenging. If they are, a recession will surely follow. If they are not, a world of permanently higher prices awaits. BM/DM