Where Did the 2% Inflation Target Originate?

Central banks all over the world have been striving for years to reduce inflation to 2%, but the figure isn’t based on any academic research.

In fact, a growing number of economists and financial experts have voiced their opinion that it has been “plucked out of the air” merely to satisfy the general public’s expectations.

Britain is one of around 60 countries, including the United States, Japan and much of Europe, to have set 2% inflation as their goal.

Following a decision by the Bank of England on 1^st February to leave the UK interest rate at 5.25%, debate in the media has turned to why 2% is considered the ideal inflation figure. This has unearthed the surprising idea that it seems to be the result of a chance comment made in 1988 by Roger Douglas, New Zealand’s finance minister at the time.

If the Bank of England inflation target has no real academic basis, some economists are wondering why the UK is still striving to reach it.

Origins of 2% inflation target

The inflation rate measures changes in the price of goods and services including house prices, utility bills, shopping and more.

The UK suffered seven months of exceptionally high inflation from September 2022 to March 2023, with the record peak of 11.1% occurring in October 2022. During this period, inflation remained in double digits. Although it has shown a downward trend in general, it is still 4.2% today - more than twice the target.

Analysts say tobacco and alcohol have replaced food as the sectors that currently have the highest rate of inflation.

Now several reports in the media have suggested the UK inflation target may be too low, especially since it doesn’t appear to have any analytical foundation. Economics professor Louis-Philippe Rochon, of Canada’s Laurentian University, wrote an editorial in The Guardian to explain why he believed 2% was plucked out of thin air.

In 1988, the New Zealand finance minister gave a TV interview to discuss the state of the economy. The nation was just starting to recover from a disastrous period of high inflation, which had rocketed to more than 15% the previous year. Trying to appease the public, Douglas made an off-the-cuff remark that he would be satisfied if the inflation rate was between 0% and 1%.

Don Brash, the Reserve Bank of New Zealand’s Governor from 1988 to 2002, took Douglas’s remark into account when determining his target for inflation. Despite the finance minister’s figures having no concrete foundations at all, Brash used them as the basis for his calculations.

He added inflation bias of around 1% to his discretionary monetary policy to come up with the figure of 2%. Inflation bias is a type of number-crunching that creates a slightly higher figure than the optimum estimate.

In later interviews, Brash’s colleague in 1988 at the Reserve Bank, Michael Reddell, reportedly admitted the system “wasn’t ruthlessly scientific”. Now aged 83, he has been quoted as saying Douglas had made “almost a chance remark” by “plucking the figure out of the air” to placate public expectation.

Today, 36 years down the line, Brash’s decision is still having repercussions on business and consumers, as the magical number of 2% has been adopted by almost 60 nations.

Does the inflation target matter?

Many economists suggest the target matters a lot and believe inflation should be raised higher to 3%. They feel 2% is too low and this impacts public morale, because people are always worrying about rising prices.

Many countries have 3% or 4% inflation, which is the norm. If the UK’s target was 3%, this would be far more achievable and realistic, critics believe. There’s a feeling it could kickstart the UK’s recovery quicker if the target was reached, as it would stimulate growth in the economy. When the target is too low, it can lead to harmful deflationary pressures, according to experts.

Benjamin Friedman, a Harvard professor, described the way the 2% inflation target was determined as a “professional embarrassment”. He finds it hard to believe that one of the world’s key economic policies is based on an “impromptu remark”, without any “serious empirical research”.

Former vice president of the European Central Bank Vitor Constâncio, Nobel prize-winning economist Paul Krugman and the International Monetary Fund’s former chief economist Olivier Blanchard are reportedly in favour of changing the inflation target to 3%.

The UK’s Resolution Foundation proposed such a change in October 2023, but economists have criticised central banks and the government, claiming they “don’t seem to be listening”.

However, other financial experts, such as Rochon, fear the proposal to simply change the target to 3% isn’t justified either, because it doesn’t involve any empirical research. He claims central banks currently have “too much power” over people’s life and livelihood when it comes to fiscal policies.

How does inflation impact businesses?

High inflation has been adversely affecting the UK’s small and medium-size businesses for around two years now, with many turning to a professional small business accountant to help identify cost savings to stay afloat.

Businesses are suffering greater costs in terms of their supply chain, which means they’re having to pass on the increases to customers. Employees are calling for higher wages to help them survive the cost-of-living crisis. All the increases are being felt by consumers, who have less money in their pocket.

With the increased competition that globalisation has brought, some business owners feel the 2% inflation target is no longer in line with the changing nature of the economy. They fear it is too ambitious, making it harder to achieve stable prices in general.

Compiling accurate annual accounts is a crucial business tool, enabling SMEs to see the complete picture of their company’s health, leading to effective budgeting for the year ahead.

While the UK’s inflation rate was 3.9% in November 2023, it rose to 4% in December. It is estimated to be 4.2% today, another slight increase. This highlights the difficulties in reducing it to such a low rate as 2%.

There have been discussions about making the inflation target more flexible. Rather than choosing a specific number, this could mean keeping the inflation rate within a specific range, which would permit central banks to maintain price stability, while actively responding to changing economic conditions.

Some critics, including Rochon, are proposing an altogether more radical solution for the future - scrapping the inflation target completely and starting afresh with a detailed examination of the world’s monetary policy and what it’s supposed to do.

It has been deemed unlikely that any central bank will simply change the target to 3%. However, economists feel it is more feasible to change how inflation is measured, or to alter the timeframe for achieving the goals, in the future but only after careful consideration based on data.