Blogs | January 5, 2016

Two to tango: how two percent became an inflation target

Wilson asks: Why do central banks set a target inflation rate of two percent, instead of some other number?


Ian answers: Wilson, it appears the two percent figure was arrived at partly by accident – in the Pacific nation of New Zealand back in 1989.

A Kiwi experiment
Inflation in New Zealand – and in other countries – had been high. In New Zealand, it had hovered between 10% and 19% nearly every year since 1970.
Price and wage freezes had not worked.
Policy makers everywhere wanted to reduce inflation but did not know how.
The New Zealand government decided to take aggressive action. It set an inflation target of zero to two percent, and made the Reserve Bank independent – able to set the official cash rate. Don Brash, the Governor of New Zealand’s Reserve Bank at the time, was made personally responsible for keeping inflation within bounds.
No other country was prepared to do this.
The world watched to see if this experiment would work.
Inflation fell to two percent, and governments in several other countries followed New Zealand’s lead.
Many central banks were made independent and inflation targets were set of around two percent.
It might be said that two percent has become an anchor point for an acceptable top rate of inflation.

Two is better than one
Brash’s memoirs, published in 2014, reveal that this target, however, was “almost accidental”.
As explained in the New York Times, New Zealand’s former minister of finance Roger Douglas – whose approach eventually passed into local parlance as “Rogernomics” – had in a TV interview suggested a target of zero to one percent.
According to Brash, this target was “plucked out of the air to influence the public’s expectations”.
Nevertheless, as the article goes on to say, Brash and finance minister at the time David Caygill used the Douglas suggestion as a starting point, eventually settling on a target of zero to two percent to give them more room to manoeuvre.
A footnote in Brash’s memoirs says: “We suspected measurement bias in the consumer price index (CPI) of about one percent.”

Let’s get real
Wilson, you also asked if the two percent target is necessary or useful. Until the global financial crisis in 2007-08, few questioned its usefulness, although some people appeared to suggest it was too high.
For much of the early 2000s, the Bank of Japan appeared to aim for inflation of around one percent.
After the crisis, slow growth and the threat of deflation dogged many countries. Central banks therefore lowered interest rates.
However, if inflation expectations are for between zero and two percent, real interest rates (the interest rate minus the expected inflation rate) typically cannot fall below minus two percent.
This limits the amount of financial stimulus that central banks can provide. So some economists have suggested raising the target inflation rate to four percent to reduce real interest rates, as this article explains.
New Zealand itself has moved the goalposts here – shifting the upper boundary for inflation to three percent in 1996 and the lower boundary to one percent in 2002.
Opponents say, however, that the resultant expectation of rising prices could give many economies a bumpier ride.
My view is that the biggest problem in many economies is persistent unemployment, due to slow growth. And if that’s the case, perhaps raising the inflation target could help.

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Ian Bright
Ian Bright

Senior economist at ING
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