Rewiring the Central Bank: Why the 2% target has had its day

On 5 November, the Bank of England raised Bank Rate to 4%, its first increase since August 2023. The decision followed another surge in energy prices arising from the conflict in the Middle East, now in its ninth month. Although the Bank also cited stronger economic activity and the risk of continuing inflation, the immediate pressure originated largely in a disruption to global energy supplies.

The decision illustrates a problem that has long troubled monetary policy. Central banks remain heavily dependent on interest rates to control inflation, even when the forces driving prices are largely beyond their influence.

No increase in Bank Rate will reopen a shipping lane.

Higher borrowing costs may restrain spending, but they cannot produce more oil or gas. For households already struggling with energy bills, a mortgage increase compounds the pressure. Small businesses face higher input costs accompanied by more expensive finance.

These decisions have a human dimension that deserves greater attention. Behind the economic statistics are families struggling to meet their obligations, businesses operating on thin margins and people facing cost-of-living challenges, whose financial security may depend on relatively modest movements in interest rates.

The consequences can be severe. Mortgage arrears, business failures, lost employment, and the anxiety that accompanies financial distress are real costs of monetary restraint, and they fall unevenly across society.

In July, the Fed established five task forces to examine its communications, balance sheet, economic data, productivity assumptions, and inflation framework. It is an unusually candid exercise in institutional self-examination.

The world’s most influential central bank is questioning whether its methods still fit the economy it now faces. The Bank of England and the European Central Bank should do the same.

When inflation has different causes

The key distinction is between inflation driven by excessive demand and inflation arising from a supply shortage.

When credit is plentiful, spending is strong and productive capacity stretched, higher interest rates have a clear purpose. They discourage borrowing, moderate consumption and investment, and gradually restore balance.

The difficulties begin when prices rise because something essential has become scarce.

Russia’s invasion of Ukraine demonstrated how abruptly energy shortages can drive inflation across an economy. The present disruption in the Gulf has renewed that experience.

Central banks cannot remedy those shortages. Their influence is confined largely to the demand side of the economy.

That does not mean they should ignore supply-driven inflation. Prolonged increases in energy prices can spread into wages and other prices. Once expectations of persistently higher inflation become established, restoring stability becomes considerably more difficult.

This is the strongest argument for the Bank of England’s recent decision, and it deserves serious consideration.

Yet the evidence remains mixed. The Bank’s November minutes acknowledge limited signs so far of higher energy costs feeding into other prices and wages. The ECB has made a similar observation, although both institutions remain concerned about the consequences of a prolonged shock.

Monetary policy must distinguish between a temporary disturbance and a sustained acceleration in domestic inflation, weighing the risks against the damage caused by suppressing economic activity.

That damage is not shared equally.

A household without debt may experience little direct hardship, while a young family with a substantial mortgage faces an immediate loss of disposable income. A large company with ample liquidity can withstand higher borrowing costs more readily than a small business dependent on its overdraft.

The people making these decisions are rarely those most exposed to their consequences.

There may also be a case for strengthening the consumer and small-business perspectives available to monetary policy committees, whether by broader appointments or more formal advisory arrangements.

Independence need not mean distance from the society monetary policy is intended to serve.

Government cannot stand aside

Responsibility for restraining inflation is placed overwhelmingly on central banks, while governments are too readily absolved of responsibility for policies which contribute to it.

Energy provides an obvious example.

Britain and Europe have embraced the transition to net zero with considerable conviction. Its environmental objectives are important, and reducing dependence on imported fossil fuels has grown more urgent after successive geopolitical crises.

But the transition carries substantial costs. Its timing, financing and the reliability of alternative supplies matter enormously.

According to the International Energy Agency, electricity prices for energy-intensive industries in the European Union averaged roughly twice those in the United States in 2025. They were more than 50% higher than in China. That is a considerable competitive disadvantage, quite apart from the burden of expensive energy on households.

The reasons are complex. Dependence on imported gas remains important, alongside network costs, taxation, policy levies and investment associated with changing the energy system.

Renewable generation may ultimately reduce exposure to volatile international fuel markets. Nevertheless, governments cannot pursue ambitious energy policies without fully accounting for their affordability and the consequences for competitiveness.

A particular injustice arises when those costs fall most heavily on people least able to bear them. Higher energy bills consume a greater proportion of poorer households’ income, and their ability to absorb further increases is limited.

A policy may be commendable in its aims while proving damaging in its implementation.

This is not confined to energy. Taxation, regulation, infrastructure and planning all influence the cost and availability of goods and services. Yet inflationary consequences can receive insufficient attention when these policies are formulated.

It is unreasonable to expect central banks to compensate for every failure of supply-side policy through higher interest rates.

Governments should take greater ownership of inflation, both in assessing the consequences of their decisions and in dealing with the underlying constraints on productive capacity.

There is also an uncomfortable political asymmetry. When inflation falls, and interest rates fall, governments are often quick to credit the improvement to their own economic management. When inflation rises, and borrowing costs increase, responsibility tends to migrate to the independent central bank.

Yet governments determine the monetary policy framework and make decisions on taxation, public spending, energy and regulation that directly influence inflationary forces. Central bank independence is an important protection against political interference, but it should not provide governments with a convenient escape from accountability for the consequences of their own policies.

There is little sense in suppressing demand through higher borrowing costs while maintaining avoidable supply restrictions.

Growth is already under pressure

These questions matter particularly in Europe, where growth remains disappointing.

The ECB has raised its deposit rate twice since June, to 2.5%, although it held rates in October. Meanwhile, underlying inflation has remained broadly stable.

Europe faces formidable competition. The United States benefits from deeper capital markets, greater energy self-sufficiency and leadership in important technologies. China combines industrial scale with substantial state-directed investment.

Europe retains considerable strengths, but expensive energy and institutional complexity weaken its position.

Britain faces much the same challenge.

The Office for Budget Responsibility expects growth of around 1¼% this year and roughly 1% in 2027. Real earnings are forecast to make no progress next year, while the public finances leave little room for manoeuvre.

Against that background, further monetary tightening carries consequences extending beyond the near-term inflation outlook.

The Bank expects UK inflation, already 3.5% in September, to reach around 5% by mid-2026. Much of that projected increase reflects internationally determined energy prices.

It is reasonable to guard against those increases becoming entrenched. The question is how much additional economic weakness policymakers should impose when the initial cause lies outside their control.

Tight money can produce a lasting mark when businesses postpone investment, employment opportunities disappear, and capital finds more attractive opportunities elsewhere.

Rethinking the inflation target

The case for reform goes beyond the interest-rate decision at any particular meeting. It reaches the framework within which those decisions are made.

The 2% inflation target has served an important purpose. It provided a clear benchmark for price stability and helped build confidence in independent central banking.

But does a single numerical target provide sufficient flexibility in an economy exposed to repeated supply disruptions?

Central banks will reasonably argue that their present frameworks already allow flexibility when inflation is driven by supply shocks. That is true. The Bank of England’s mandate explicitly permits temporary departures from target when returning inflation too quickly would cause undue economic disturbance.

Yet the obligation to return inflation to a particular point sways policy decisions. I question whether that degree of numerical precision is necessary when the economic and social costs of achieving it may be considerable.

If inflation were running at 2.7% because of identifiable supply pressures, while domestic demand remained weak and expectations stable, there would be little justification for imposing additional restraint to return the number to 2%.

Equally, inflation of 2.5%, driven by excessive credit growth and an overheating economy, might warrant intervention.

The source and likely persistence of inflation should matter more than the decimal point.

An increase beyond the range would still require a credible explanation and an appropriate response. Sustained price increases accompanied by rising expectations should not just be ignored.

Critics will reasonably argue that loosening the numerical anchor risks undermining confidence. That danger must be taken seriously. Any reform would require a clear mandate, continued independence and transparent accountability.

But credibility also depends upon the public believing that policy decisions are proportionate and economically rational.

A central bank that repeatedly sacrifices growth for numerical exactness may ultimately undermine the confidence it seeks to preserve.

A wider choice of instruments

Changing the target would not resolve the shortage of policy instruments.
Central banks remain largely dependent on interest rates, quantitative easing and its reversal. These measures influence the economy broadly, regardless of which sectors drive inflation or which households are least able to bear the consequences.

There may be scope for more discriminating approaches.

Singapore’s Central Provident Fund demonstrates that compulsory retirement saving can operate successfully over many decades, although it was not designed as an instrument for short-term inflation oversight.

A suitably designed provident fund could operate with a permanent base contribution and a temporary supplementary rate, activated when inflationary forces reflected excessive domestic demand.

Such an arrangement might offer two benefits. Higher inflation diminishes the purchasing power of retirement savings, and additional contributions could help compensate for some of that loss.

At the same time, temporarily diverting income from consumption into longer-term savings could moderate demand and help relieve inflationary pressure.

The attraction is that the money would remain the individual’s property, accumulating toward retirement rather than being absorbed by increased interest payments. There would be an immediate sacrifice of spending power, but potentially a lasting personal benefit.

Additional contributions would not guarantee protection against inflation, since the real value of retirement savings ultimately depends upon investment returns. They would, however, increase the retirement capital available to the individual while feasibly moderating immediate demand.

The idea would call for careful testing. Its effect on demand would depend partly on how the funds were invested. Safeguards would also be needed for lower-income households, whose ability to make additional contributions may be limited, and the burden on smaller employers would need consideration.

Nor would such a mechanism resolve inflation caused by energy shortages. It would be more relevant when excessive domestic demand was the problem.

Nevertheless, it raises a worthwhile question. If policymakers need to restrain consumption, why should the adjustment invariably take the form of higher borrowing costs, rather than mechanisms that might also strengthen the financial security of those making the sacrifice?

A more accountable framework

Warsh’s review raises other issues deserving attention. Forward guidance can become a constraint when markets mistake projections for commitments. The balance sheets accumulated through quantitative easing have blurred aspects of the relationship between monetary and fiscal policy.

Official economic statistics frequently arrive late or are revised, while digital sources can deliver timely evidence of changing conditions. Artificial intelligence may also alter productivity and the relationship between growth and inflation in ways conventional models do not adequately capture.

These are important technical questions, but institutional reform should reach beyond the machinery of central banking.

The social consequences of monetary restraint deserve greater prominence in policy deliberations. The public should understand not only how an interest-rate increase might reduce inflation, but also the likely economic and social price of achieving that result.

An increase may ultimately be justified. Its consequences should nevertheless be openly acknowledged and carefully weighed.

Central bank independence confers considerable responsibility. It should not shield policymakers from scrutiny of the wider effects of their decisions.

None of this argues for abandoning monetary discipline. Inflation itself imposes serious hardship, particularly on people whose incomes cannot keep pace with rising prices.

The issue is whether our present arrangements provide the most intelligent and proportionate means of sustaining stability.

Britain and Europe should undertake fundamental reviews of their inflation frameworks, examining the available instruments and the responsibility governments bear for inflation arising from their own decisions.

Price stability continues to be essential. So do employment, financial security and the ability of families and businesses to plan for their futures.

The Fed has started asking the right questions.

Europe and Britain cannot afford to keep giving the old answers.