Home Economic Trends The Origins of the 2 Percent Inflation Target – Robert Aro (09/18/2020)

The Origins of the 2 Percent Inflation Target – Robert Aro (09/18/2020)

Inflation targets are part and parcel of central banking policy, the Fed’s mandate centering around the 2 percent inflation target. But when was the last time anyone asked why a 2 percent inflation target?

To address this while avoiding potential “bias,” we can look at history through the lens of one of the largest mainstream newspapers in the world, the New York Times. The following article takes us back to 2014 when the paper published “Of Kiwis and Currencies: How a 2% Inflation Target Became Global Economic Gospel.”

It all started in 1989, when Don Brash, managing director of the New Zealand Kiwifruit Authority accepted the position of head of the Central Bank of New Zealand. Appearing to have no understanding of Austrian economics, he and his finance minister devised a plan to combat the surging price inflation of the ’70s and ’80s.

As fate would have it, Mr. Brash remembered the former finance minister telling the media he was “aiming for inflation of around zero to 1 percent.” Brash recalls that “it was almost a chance remark,” yet it sparked one of the most destructive policy decisions of all time, which has only worsened since. He admitted:

The figure was plucked out of the air to influence the public’s expectations.

Ultimately the bank settled on an “inflation target” between 0 and 2 percent. The announcement was considered a “radical idea” at the time, but lo and behold:

It created a kind of magic of its own. Merely by announcing its goals for inflation…New Zealand made that result a reality.

Of course, no proof has ever been offered of how an “inflation target” can be met simply by stating it as a goal. If it were that easy, the Fed would have met the target decades ago.

Luckily for Brash, inflation in New Zealand was 7.6 percent in 1989 when the target started and only 2 percent by the end of 1991. This bit of providence accelerated the idea as the head of the central bank

did a bit of a global campaigning, describing New Zealand’s success to his fellow central bankers at a conference in Jackson Hole, Wyoming.

Canada, Sweden, and Britain soon followed in New Zealand’s footsteps and eventually even the Fed. Our fate was sealed on the whim of policymakers.

It was not without opposition, though, as there were some naysayers who believed that

A dollar today should have the same buying power as a dollar in a decade, or two or three.

However, the “alternate” view was that keeping inflation low could be dangerous. This was championed by an up and coming Fed governor, Janet Yellen, who expressed concern that zero inflation could “paralyze the economy,” especially during economic downturns. In a 1996 July Federal Open Market Committee (FOMC) meeting she offered an idea to support targeting:

To my mind the most important argument for some low inflation rate, is the “greasing-the-wheels argument” on the grounds that a little inflation lowers unemployment by facilitating adjustments in relative pay in a world where individuals deeply dislike nominal pay cuts.

Here we see the “Phillips curve” argument that is used to justify inflation by linking it to unemployment. This is move that now, twenty-four years later, the Fed is shying away from by claiming that the “Phillips curve is flat”—in other words, it’s not working as planned. Or, as Fed vice chair Clarida expressed it, models of maximum employment “can be and have been wrong.”

Adding to the prophetic quotes, Yellen said in 1996:

A little inflation permits real interest rates to become negative on the rare occasions when required to counter a recession. This could be important.

The rest, as they say, is history. In time, the idea of a 2 percent target became economic orthodoxy—so much so that former Fed vice chair and Princeton economist Alan Blinder declared that

Central bankers have invested a lot and established a great deal of credibility on their 2 percent inflation target, and I think they’re right to be very hesitant to give it up.

By choosing an inflation target of 2 percent, the field of economics spent several decades barely advancing. Instead, academics and planners remained preoccupied with manipulating the data and providing guidance fueled by a narrative that was plucked out of thin air, aided by catchy phrases such as “greasing the wheels,” and propagated by outdated economic models like the Phillips curve. Sadly, with 2 percent inflation the conclusion came first, followed by the theory. Economic explanation was only needed to support the theory at all costs.