Inflation targeting has been the guiding principle for G7 central banks since 1990, when the Reserve Bank of New Zealand introduced the idea.
The theory is straightforward. If prices rise a little each year, say 2%, that is enough to encourage people to spend now rather than wait for prices to rise further.
It should not be so much that it spooks the horses and creates a demand-driven boom and bust. Smoothing the cycle in this way is meant to encourage investment and improve productive capacity. That is more psychology than economics. And it rests on an assumption that inflation is primarily a demand problem.
Consumption drives economic performance in the West; 68% of US GDP comes from personal expenditure, against 1.8% for capital expenditure in artificial intelligence, headline-grabbing as that spending has been. Stimulate or curb consumption and you control activity, or so the theory goes.
The trouble is that supply side economics gets far less attention. What companies and governments do to meet demand depends on far more than productive capacity.
Infrastructure links and trade tariffs matter too. And an interruption to supply can hit growth and inflation faster and harder in the short term than anything on the demand side.
Throwing fuel on the inflation fire
Central banks have a poor track record of telling the difference. Look at the inflation shocks of the 1970s or 1980s. More recently, look at what happened during the Covid-19 pandemic.
Governments flooded consumers and businesses with cash just as there was almost nothing to buy, with goods not being shipped and restaurants closed. Effectively, supply collapsed and what was produced fetched absurd prices.
Central banks responded by cutting rates and easing further, throwing fuel on a fire that demand had not lit. They were treating a supply problem as a demand problem.
The result was a spike in consumer price inflation, a widening in wealth inequality and a cost-of-living crisis that has taken the best part of five years to work through, not to mention deeply indebted governments and corporations that borrowed far too cheaply along the way.
We are in a similar position today. Oil prices have spiked, largely due to the increasingly familiar flip between truce and war around the Strait of Hormuz. That, on its own, will not cause inflation.
As in 2020, this is a supply shock, not a symptom of demand growth. Energy prices will need to stay elevated, or ideally grind higher, for the best part of a year before they embed themselves in consumer psychology and inflation expectations start to shift.
Higher energy prices do put upward pressure on wages, but also erode discretionary spending, so there is no guarantee that will translate into real growth.
July's US employment report made the point rather well, with job losses, falling real wages and, most tellingly, a drop in the participation rate that bodes poorly for growth ahead.
If anything, it argues for pre-emptive rate cuts to protect demand, not hikes in response to supply problems central banks cannot control.
Rate rises can take a hike
Central banks are meant to look two to three years ahead, not fret over today's oil price. And, over that horizon, there is little to no evidence of a sustained CPI surge.
Yet investors, politicians and increasingly central banks themselves appear to have developed a form of economic myopia, dealing with the threat in front of them rather than the one on the horizon.
Should oil sit at $90 by the time the Fed or the ECB next meet, do not be surprised if they raise rates regardless, even though it could fall to $70 the following day and start creating deflationary pressures instead.
G7 growth, employment and inflation are all broadly around trend despite the oil shock. There is little reason to hike now, unless your focus stops at today.
The mismatch between where central banks are looking and where the evidence points is exactly the kind of short-termism bond investors should look through and potentially profit from.
Take 30-year treasury bonds, which currently yield around 5.2%. According to forecasts, yields will fall to 4.88% within two years, in line with a modest reduction in rate expectations.
If investors were to purchase those bonds today, the capital gain alone could be worth close to 5% over the next two years while the total return, including coupons, would be in the region of 15%.
Ten-year treasuries, currently yielding 4.7%, are expected to experience a similar-sized drop in yield, to 4.4%, which would result in a capital gain of around 2% and total return closer to 11%.
With central banks fighting today’s war, the reward for taking a two-to-three-year view, and being positioned in duration now, could be considerable.
That includes the many investors currently parked in money market funds, as they will be relative losers as and when rate hikes are back on the central bank agenda.
David Roberts is head of fixed income at Nedgroup Investments. The views expressed above should not be taken as investment advice.