Resources | Market Trends | October 26, 2023

Many Nations Are Trying to Reach an Inflation Target of 2% — Does That Still Make Sense?

Some economists are suggesting a higher guideline might make more sense.

Some economists are suggesting a higher guideline might make more sense.

As they have raised interest rates, the US Federal Reserve, the European Central Bank and other policymakers have been clear about their ultimate goal. They want to bring annual inflation rates back down to around 2%, even if that takes time to achieve. 

But critics have started to question whether 2% is still a reasonable inflation target. To reach that point, central banks might have to keep interest rates elevated for an extended period of time, leading to higher costs for consumers, increased layoffs and a slower economy overall. 

Some experts argue the economy has undergone a structural change due to a tightening labor market and other factors. As a result, it might make more sense to accept a slightly higher target rate so policymakers can reduce interest rates. 

Why is the inflation target 2%? 

It’s useful to understand why so many countries use 2% as their inflation target. To do that, we have to look at New Zealand.

In a 1988 TV interview, that country’s finance minister was asked if he was happy with New Zealand’s inflation rate of 10%. He said that, ideally, inflation should be somewhere between 0% and 1%. 

As a result of the interview, the Reserve Bank of New Zealand decided it probably should calculate an official inflation target. 

Policymakers there found research saying that inflation estimates often have an “upward bias” and are usually higher than reality. Some rough calculations determined that New Zealand’s upward bias was about 0.75%, which they rounded up to 1%. 

Add that to the finance minister’s 1% ideal, and ta-da: New Zealand’s official inflation target was 2%, which the country formally adopted in 1988. Soon, other countries like Canada, Australia, Sweden and the United Kingdom declared similar targets.

Most developed economies now use 2% as their official guideline, though it took some longer to adopt it. The United States and Japan didn’t set 2% as their inflation target until 2012 and 2013, respectively. The European Central Bank had a goal of “below but close to 2%” for several years but changed it to a flat 2% over the medium term in 2021

While an inflation target seems like a firm number, sometimes there is wiggle room. 

In 2020, for example, the Fed said it was moving from a strict 2% to an average of 2% over time, meaning it would accept periods where inflation was higher 2% to balance out times when it was below 2%. 

As the Federal Reserve of St. Louis noted, this is a big change. In recent years — until the pandemic, at least — the Fed rarely saw inflation above 2% and would move aggressively if the trend line looked like it might rise above 2%. 

Not every nation uses 2% as its inflation target. The Reserve Bank of India, for example, has a goal of 4% with a “tolerance band” of 2% above or below that figure. That way, food and fuel costs, which tend to be volatile, can rise or fall somewhat before pushing the country’s inflation out of the desired range. 

Does 2% actually make sense as an inflation target?

Even if it seems a little arbitrary, a target rate of 2% generally has been a good goal for many economies. 

For starters, it’s a low enough figure that — if it’s stable — it allows most households and businesses to make plans and adapt quickly to mild increases in prices, which allows the overall economy to flourish, the Federal Reserve argues. Price stability, after all, is one of the Fed’s two missions. 

And the other Fed objective — keeping unemployment low — benefits from 2% inflation, too. That way, if there’s a recession, the bank has a little room to cut interest rates to spur economic growth. That wouldn’t be as easy with inflation near 0%. At that level, an interest rate cut could theoretically push the economy into deflation. 

The case for — and against — a higher inflation target

Accepting a higher inflation rate means that central banks could dial back some of their recent interest rates, making credit more affordable and spurring economic growth. Proponents argue that, in time, consumers would adapt to a slightly higher rate of average inflation. 

A higher inflation rate would also give central banks more “firepower” during recessions because they could lower interest rates to a greater degree, as a spur to economic investment and activity.  

But raising the inflation target from 2%, even if it’s ultimately a good idea, isn’t as easy as just announcing the change. 

One reason to have an inflation target is to influence public expectations of inflation. Most businesses and households believe that, even if inflation is well above average now, it will eventually, predictably return to 2%. That influences how they spend money and invest.

Changing the target could mean unsettling the public’s perception. There’s a risk that most people would believe that, if the target changed once, it could change again. 

And if businesses and people think that inflation will just keep growing and growing, it will lead them to take actions (like raising prices and pushing for higher wages) that ensure inflation happens — a self-fulfilling prophecy. 

The bottom line on inflation targets

At this point, there’s no sign that central bankers intend to change their inflation targets. That could change, though, after the current period of high inflation ends and policymakers try to apply the lessons they learned. 

Or if inflation remains stuck at around 4%, they may be tempted to accept a higher rate so they can dial down interest rates. 

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