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HARD TARGET

The Fed’s inflation target comes from a casual remark on New Zealand TV

Don Brash talks to the media after casting his vote in Auckland during New New Zealand's general election in 2005
Reuters
Don Brash was New Zealand's central banker from 1988 to 2002.
  • Samanth Subramanian
By Samanth Subramanian

Looking into the Future of Capitalism

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At least since 1996, the US Federal Reserve has used monetary policy with the aim of keeping inflation at 2%—a number that Ben Bernanke, the former Fed chair, made an explicit policy target in 2012. And it isn’t the only central bank in the developed world to shoot for 2%.

The Bank of Canada has the same target, as do Sweden’s Riksbank, the Bank of Japan, and the European Central Bank. The Bank of England is so devoted to its 2% target that its governor must write a letter to the chancellor of the Exchequer if inflation moves more than a percentage point in either direction. Andrew Bailey, the current governor, sent such a letter in May, pointing out that weakened economic activity during the pandemic had caused prices to tumble in the 12-month period ending February.

But why did these banks uniformly gravitate to the 2% figure? And where did that number come from?

From New Zealand, it turns out: specifically, from a finance minister who was put on the spot during a TV interview in 1988.

Why is the inflation target 2%?

When Don Brash became the governor of the Reserve Bank of New Zealand in September 1988, his country was slowly recovering from a spell of heated inflation; just a year or so previously, the rate had surged past 15%. At the time, central banks around the world certainly tried to ensure stable prices, but they used different measures to gauge their effectiveness: the exchange rates of their currencies, for instance, or the rate of growth of money supply.

“The Labour government at the time was very keen to deal with inflation” Brash remembered. “They instructed the Reserve Bank to get it down, without getting too precise about what getting it down meant.” A few months before Brash assumed his post, Roger Douglas, New Zealand’s finance minister, went on TV to talk about the government’s approach to monetary policy. This involved targeting inflation specifically—a method that had kicked around in economic literature for years but that hadn’t been implemented anywhere.

At the time of Douglas’ TV appearance, the inflation rate had just dipped below 10% for the first time in some years. Brash recalled that Douglas’ interviewer asked him: Was the government satisfied now, with this lower level of inflation?

No, Douglas replied, adding that he’d ideally want an inflation rate of between 0 and 1%.

The remark was entirely off the cuff, Brash said, but now that it had been made, the Reserve Bank had to work out what the inflation target should be. After Brash joined the Reserve Bank, he and his colleagues learned from the literature on cost-of-living estimates that there tended to be an “upward bias” to these calculations—that an inflation rate worked out to be 1.7%, say, might in reality be closer to 1% or 0.7%.

Brash and his team estimated the bias for New Zealand to be around 0.75% and rounded it up to 1%, which gave them a maximum target boundary of 2%. “It wasn’t ruthlessly scientific,” Michael Reddell, one of Brash’s colleagues at the Reserve Bank, admitted. But once the target was set, its gospel had to be spread, so that people could factor the 2% figure into their economic activities. “I spent an endless time traveling the country,” Brash said. “I talked to farmers, to Rotary groups, to anyone who would listen, saying: ‘This is going to be the target, so adjust your plans to that, or the social and economic costs will be considerable.'”

The history of inflation targeting

After New Zealand’s policy took off, inflation targets became “all the rage,” as the economist Mervyn King said in a speech in 1997. The next country to adopt inflation targeting was Canada, and it too settled on 2%. So did several countries further down the line. Brash explains this, with a laugh, as an example of how ideas spread within the small priesthood of central bankers: “I mean, we’d meet in Basel and other places and talk about this stuff.”

But 2% also had a pragmatic ring to it. For one thing, countries like New Zealand had learned that high inflation didn’t necessarily bring high economic growth with it, so bankers wanted a low, stable number. At the same time, 2% didn’t feel too low; too low would have been undesirable, because it would have pushed down interest rates so much that, if a recession came around, bankers couldn’t have cut rates much further to boost the economy.

In 1992, the Bank of England began aiming at an inflation target of 1-4%. Five years later, the UK put into place a structure similar to New Zealand’s, in which the government would declare the inflation rate it desired, leaving the Bank of England to meet that demand. The target announced that year, of 2.5%, was revised to 2% in 2003, when King became the Bank of England’s governor. 

American economists began swiveling around to publicly set an inflation target in the mid-1990s. Although they had internally been using 2%, some Fed officials, including Janet Yellen, remained wary of even an internal target, let alone a publicly announced one. But as the idea picked up steam around the world, the Fed began discussing whether an explicit target ought to be declared—and, if so, what that target ought to be. One analysis of Federal Open Market Committee transcripts up to 2013 shows that officials overwhelmingly favored a 1.5% target at first. After the 2008 recession hit, though, consensus shifted to 2%, which gave the economy more room to grow—and, just as importantly, gave bankers more leeway to use interest rate cuts to spur the economy in dire slowdowns like the one that had just passed.

Is a 2% inflation target the right one?

Inflation targeting took such deep hold in these economies that it came to resemble a kind of orthodoxy. Many economists, including King, worried that central bankers fixated too much on inflation and not enough on other economic signals like unemployment or growth data; King once called such bankers “inflation nutters.” Last year, Jerome Powell, the Fed’s chair, announced that the Fed will move away from King’s nutter-ism to a more flexible approach, targeting an average inflation rate of 2% over a longer period of time, rather than at every point in time. The Bank of Japan too is under pressure to consider a similar, flexible targeting approach.

Some experts have called for a higher target, particularly in the wake of the 2008 crisis. In a 2010 paper, Olivier Blanchard, the International Monetary Fund’s chief economist, wondered if aiming for 4% inflation would give central bankers even more space to cut rates and boost growth, protecting it from “the effects of a pandemic on tourism and trade or the effects of a major terrorist attack on a large economic center.” Alan Blinder, the former vice-chair of the Fed, noted in a 2018 speech that, in the 1990s, no one predicted the coming era of low real interest rates and deep recessions. “Would the consensus still have settled on 2%?” Blinder said. “Maybe not.”

But it’s no simple matter to change the target figure after all these years, Brash said: “If you move it from 2% to 4%, then people will wonder when you’re going to move the target next.” Shaking the expectation of stability is, in a way, as unsettling to markets as anything else. In a survey of central bankers in 2017, Blinder found that few were willing to raise their inflation targets. “I don’t think they are wrong about this, or just being stubborn,” he said. For better or worse, the 2% figure—articulated on the basis of that impromptu comment on television—has planted itself so firmly into macroeconomic soil that it will prove very difficult to uproot.

Correction: The new Zealand finance minister whose TV comments are the basis for the 2% inflation target was Roger Douglas. An earlier version of this article identified him as David Caygill.

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