The New Zealand parliament’s unanimous adoption of what became a 0 to 2 per cent inflation goal for its central bank in December 1989 — the world’s first such target — may owe a certain amount to MPs’ eagerness to dash off for Christmas, and an offhand remark by a former finance minister. Despite its chance beginnings, the 2 per cent benchmark was widely adopted and helped underpin decades of low and stable inflation in advanced economies — until the pandemic and Russia’s invasion of Ukraine. As central bankers assess how far to take interest rates to return high, albeit easing, inflation back to target, there is a growing debate over whether 2 per cent is indeed sacrosanct.
This week the US Federal Reserve, the Bank of England and the European Central Bank were again unwavering in their commitment to 2 per cent. Each raised rates by a slower 50 basis points, on top of hefty increases this year. Terminal rates are in sight, but “more work to do” remains the mantra. In the UK and the eurozone inflation is still over five times the target. The Fed and ECB’s latest forecasts showed price growth at 2.1 and 2.3 per cent, respectively, in 2025.
There are reasons for optimism: global price pressures are easing, headline rates are falling, further rate rises are scheduled, and slowdowns next year will dampen prices further. Yet the task of reaching 2 per cent is not any easier. Core inflation — which excludes energy and food — remains high, partly buoyed by red-hot labour markets and robust wage growth. These price pressures may persist. The ECB projects underlying price growth still at 2.4 per cent in 2025. The war in Ukraine and China’s reopening are among a number of upside risks. Broader trends including the climate transition, trade tensions, ageing populations, and state spending pressures could also keep prices aloft.
If inflation is more stubborn, why not raise the target — as some economists are suggesting. After all, pushing rates even higher to curb demand and hit 2 per cent means more job losses and deeper recessions. Indeed, the Fed now expects its hiking cycle to peak higher at 5.1 per cent in 2023, with unemployment expected to top 4.6 per cent, up from 3.7 now, as a result. A higher target would reduce the pressure to raise rates.
Given its arbitrary foundations, there could be room for manoeuvre. Two per cent was considered low enough not to impose significant economic costs, yet sufficient to allow prices and wages to adjust smoothly. A slightly higher target may be feasible: recent research suggests inflation may only become particularly salient with the US public above around 3-4 per cent. It may also be an opportunity: a higher target means higher average nominal interest rates, and more space to cut rates to rev up economies in bad times.
But as inflation trends down, stopping off sooner than the public, businesses and investors expect has harmful implications. After falling behind the curve, central bankers have spent much of the year talking and acting tough about getting back to 2 per cent. Long-term inflation expectations are well-anchored by the target. Shifting the goalposts after being wide of the mark for 18 months would damage central bank credibility. If they can just change targets, why believe what they say next?
A better policy would be to first bring inflation back down to 2 per cent, before considering if and how monetary policy may be reformed. That was indeed the message delivered by Fed chair Jay Powell when asked this week whether the Fed would abandon its goal. Even if the 2 per cent target’s origins are capricious, it is the promise of meeting it that has helped tame inflation for decades. For now at least, 2 ought to remain the magic number.
