Why Central Banks Target 2% Inflation

Key Concepts

Inflation Targeting: The practice by central banks of publicly announcing a specific inflation rate they aim to achieve.
Price Stability: The objective of maintaining stable price levels in an economy, typically a primary mandate for central banks.
Monetary Policy: Actions undertaken by a central bank to manipulate the money supply and credit conditions to stimulate or restrain economic activity.
Inflation Expectations: The beliefs held by individuals and businesses about future inflation rates, which can influence current economic decisions.
Credibility: The degree to which a central bank is trusted by market participants to achieve its stated objectives.
Interest Rates: The cost of borrowing money or the return on lending money.
Real Wages: Wages adjusted for inflation, reflecting the actual purchasing power of earnings.
Deflation: A sustained decrease in the general price level of goods and services.
Deflationary Spiral: A vicious cycle where falling prices lead to reduced spending, lower profits, job losses, and further price declines.
Menu Costs: The costs incurred by businesses when they have to change their prices.
Tax Brackets: Ranges of income taxed at different rates.
Consumer Price Index (CPI): A measure that examines the weighted average of prices of a basket of consumer goods and services.
Core CPI: CPI excluding volatile components like food and energy prices.
Substitution Effect: The tendency for consumers to substitute cheaper goods for more expensive ones when prices change.
Inertia: The tendency for a system to remain in its current state due to resistance to change.

The Bizarre Origin and Justification of the 2% Inflation Target

The Genesis of Inflation Targeting in New Zealand

The video delves into the origins of the 2% inflation target, tracing it back to New Zealand in 1989. Amidst high inflation rates globally and within New Zealand itself (double-digit inflation), the country passed legislation to grant its central bank independence. As part of this, the Finance Minister and the head of the central bank were instructed to establish an inflation target. The initial target settled upon was a range of 0% to 2% inflation annually.

The specific figure of 0-2% is attributed to a seemingly arbitrary source: a TV interview by the previous Finance Minister, Roger Douglas, who expressed a desire for inflation between 0% and 1%. This figure was then allegedly adopted, with the upper bound extended to 2% for increased flexibility. The transcript highlights the lack of a robust or empirical process behind this foundational decision, stating, "This monumentally important figure was effectively pulled out of thin air."

The Mechanism of Inflation Targeting: Anchoring Expectations

Despite its unconventional origin, the policy in New Zealand appeared to be successful, with inflation dropping from double digits to within the target range within a few years. The key insight is that communicating an inflation target helps central banks achieve their objective by influencing inflation expectations.

When a central bank is perceived as credible and independent, its stated inflation target can anchor these expectations. This means market participants, such as banks setting loan interest rates and unions negotiating wage increases, will factor the target inflation rate into their decisions. For instance, banks might assume a 2% interest rate for loans, and unions might bargain for a 2% annual salary increase to maintain purchasing power. These actions, in turn, contribute to inflation actually reaching the targeted 2%.

Arguments for Targeting a Low Positive Inflation Rate (Including 2%)

The video outlines several key justifications for targeting a low positive inflation rate, which have become standard arguments for maintaining the 2% target:

Minimal Impact on Purchasing Power (Short-Term): A 2% inflation rate is considered low enough not to significantly erode the purchasing power of money on a year-to-year basis. While long-term savings will lose value (a dollar today loses half its value over 35 years at 2% inflation), the short-term impact is deemed minimal.
Room for Monetary Policy: Targeting inflation above 0% provides central banks with more flexibility to conduct monetary policy.
- Interest Rates: Inflation directly impacts interest rates. Lenders demand compensation for the loss of value of the money they lend. Higher expected inflation leads to higher nominal interest rates.
- Stimulating the Economy: A higher inflation target means higher potential interest rates, giving central banks more room to cut interest rates to stimulate the economy during a recession. 0% interest rates are generally considered a lower bound, although negative rates have been observed.
Facilitating Real Wage Adjustments: A positive inflation rate makes it easier for companies to adjust real wages downwards in response to economic shocks.
- Economic Shocks: During recessions, demand falls. Ideally, economies stabilize by companies reducing wages, laying off employees, and lowering prices.
- Practicality: Wage cuts are rare in practice; companies often resort to layoffs. With positive inflation, companies can keep nominal wages stagnant, effectively reducing real wages without explicit cuts. This can help the economy normalize and reach equilibrium. The same principle applies to interest rates, which can become negative in real terms with positive inflation.
Avoiding Deflation: A positive inflation rate, like 2%, is viewed as high enough to prevent deflation (falling prices). Since inflation often deviates from targets, a higher target reduces the likelihood of prices dipping into deflationary territory.

The "Boogeyman" of Deflation and its Consequences

The video addresses why economists generally fear deflation, contrasting it with the perceived benefit of falling prices for households with savings.

Reduced Economic Activity: Deflation is thought to disincentivize spending as consumers anticipate lower prices in the future, leading them to postpone purchases. This contrasts with inflation, which encourages spending.
Deflationary Spiral: A significant fear is the deflationary spiral. Falling prices lead to lower company profits, prompting cost-cutting measures like job losses and wage reductions. This further reduces spending and investment, creating a vicious cycle of falling prices and economic contraction. This can be difficult to escape with monetary policy due to the lower bound on interest rates. Japan's "lost decade" in the 1990s, characterized by sluggish performance and low inflation/deflation after a market crash, is cited as an example.
Impact on Debt: Deflation increases the real burden of outstanding debts. Fixed dollar amounts for mortgages and credit cards become more valuable in real terms, making them harder to repay, especially if incomes are falling. This is a significant concern given the high levels of debt in many economies.

Nuances and Criticisms of Inflation Targeting

The video acknowledges criticisms and complexities surrounding inflation targeting:

Uneven Impact: While theoretically incomes should rise with inflation and savings rates should compensate for lost spending power, this doesn't always happen in practice. Wages can lag behind price increases.
Measurement Challenges: Measuring inflation accurately is difficult. The Consumer Price Index (CPI) and Core CPI are commonly used, but they may not fully capture household experiences due to factors like the substitution effect, where consumers alter their spending habits based on price changes.
Costs of Inflation: Beyond savings erosion, inflation incurs menu costs for businesses and can lead to a higher tax burden on households if tax brackets are not indexed to inflation, resulting in higher nominal incomes being taxed at higher rates even if real wages haven't increased.
Empirical Evidence: It is challenging to empirically prove which targeting regime (moderate inflation or deflation) is optimal for economic activity. Persistently deflationary economies often predate robust data collection methods.
Unexpected Inflation/Deflation: What is more broadly accepted as detrimental to economic activity is unexpected inflation and deflation, as they are more disruptive to market equilibrium.
Arguments for Higher Targets: Some economists, like former Fed Chair Alan Blinder, have suggested that a higher inflation target might have been a better choice, arguing that a "somewhat bigger inflation target would have been a better choice."

The Role of Inertia and Credibility

A significant reason for the persistence of the 2% target, despite its arbitrary origin, is inertia. Changing a long-established inflation rate could negatively impact the credibility of central banks, which is crucial for inflation targeting to work. Therefore, the current 2% target is partly maintained due to the difficulty of changing it.

While the numerical target might be fixed, inflation targeting methods have evolved. Many central banks have moved from targeting a range to an explicit figure, while increasing the time horizon for achieving objectives and placing greater emphasis on factors like employment.

Conclusion

The 2% inflation target, while originating from an arbitrary decision, has become a cornerstone of modern central banking. Its justifications revolve around maintaining purchasing power in the short term, providing room for monetary policy, facilitating real wage adjustments, and crucially, avoiding the feared consequences of deflation. However, the video highlights the complexities, measurement challenges, and potential downsides of inflation, as well as the difficulty in empirically proving the optimal target. The persistence of the 2% target is also influenced by the need to maintain central bank credibility and the inertia of established policy.

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