Is 2% The Right Inflation

People the world over have been facing a poisonous new economic reality, as inflation has emerged from multi-decade hibernation.  And many of the people dealing with it are too young to remember when inflation was last a serious issue.  It is economically damaging, socially corrosive, and very hard to bring down.

Both the U.S. Federal Reserve (Fed) and the European Central Bank appear dead set on getting inflation back to their 2 percent target. Why did these and other banks, such as the Bank of Canada, Sweden’s Riksbank, and the Bank of England gravitate to this 2 percent figure?

In January 2012, a thousand years ago in internet time, the Fed, under Chairman Ben Bernanke, formally adopted an explicit inflation target of 2 percent. This marked the first time the Fed ever officially established a specific numerical inflation target. The 2 percent target was seen as a way to provide clarity and enhance the effectiveness of monetary policy.

Bernanke’s successor Janet Yellen and current chair Jerome Powell maintained the 2 percent inflation target. While Powell has a laser focus on the 2 percent target, the Fed has recently moved to a more flexible 2 percent average over time. This means the Fed would tolerate some periods of inflation above 2 percent to offset periods when inflation was below that level.

The 2 percent target was not established based on any specific formula or fixed economic rule. Despite its widespread adoption by central banks, there is little empirical evidence to suggest that 2 percent is the platonic ideal for addressing the Fed’s dual mandate of price stability and maximum employment.

This inflation target is an arbitrary number that originated in New Zealand. Surprisingly, it came not from any academic study, but rather from an offhand comment during a television interview.

During the late 1980s, New Zealand was going through a period of high inflation and inability to achieve stable economic growth – the financial equivalent of a bloody nose.  In 1988, inflation had just come down from a high of 15 percent to around 10 percent. New Zealand’s finance minister, Roger Douglas, went on TV to talk about the government’s approach to monetary policy.

He was pressed during the interview about whether the government was satisfied with the new inflation rate.  Douglas replied that he was not, saying that he ideally wanted inflation between zero and 2 percent.  This involved targeting inflation, a method that had kicked around in economic literature for years but had not been implemented anywhere.

At the time there was no set target for inflation in New Zealand; Douglas’ remark was completely off the cuff. But the inflation target caught the attention of economists around the world and went viral, becoming a kind of orthodoxy.  The approach gained recognition and as noted, was subsequently adopted by many other central banks, making inflation targeting a widely used monetary policy strategy – a classic example of how ideas spread within the small priesthood of central bankers.

The hard truth is that many economic luminaries have tried to come up with what is thought to be the optimum inflation rate, but with little success.

All things considered the 2 percent target was seen as a kind of sweet spot for inflation despite the lack of serious intellectual groundwork. Simply stated, there is nothing magical about 2 percent.  It is low enough that the public doesn’t feel the need to think about inflation, but not so low as to stifle economic growth.  That’s how it goes, but not so much more.

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