Why central banks target 2 percent inflation and not zero
The surprising origins and economic rationale behind the 2 percent inflation target.
In 1989, New Zealand's Reserve Bank set a precedent by adopting an inflation target of 0% to 2%, a figure that was, by some accounts, chosen somewhat arbitrarily. This approach quickly gained traction, with major central banks like the Bank of England and the U.S. Federal Reserve adopting similar targets.
By 2012, the Fed had officially established a 2% inflation target under Chairman Ben Bernanke, aligning with the European Central Bank's definition of price stability as an inflation rate close to, but below, 2%.
Why not aim for zero inflation?
While zero inflation might seem ideal, several economic considerations make a 2% target more practical:
Avoiding deflation: Deflation, or falling prices, can lead to reduced consumer spending and increased debt burdens, potentially triggering economic downturns.
Wage flexibility: With a modest inflation rate, employers can adjust real wages without cutting nominal pay, which is often resisted by employees.
Policy effectiveness: A 2% inflation rate provides central banks with a buffer to lower interest rates during economic slowdowns without hitting the zero lower bound, beyond which traditional monetary policy becomes less effective.
The role of inflation expectations
Stable inflation expectations are crucial for economic planning. A consistent 2% target helps anchor these expectations, reducing uncertainty for businesses and consumers.
Criticisms and ongoing debates
Some economists argue that the 2% target lacks a solid empirical foundation and may be too low, especially in the face of persistent economic challenges.
For instance, the Reserve Bank of Australia's adherence to this target has been questioned, with suggestions that a higher target could provide more flexibility in responding to economic shocks.
Conclusion
The 2% inflation target, though somewhat arbitrary in origin, has become a standard for central banks aiming to balance price stability with economic growth. While not without its critics, this target is seen as a practical compromise that allows for wage flexibility, effective monetary policy, and anchored inflation expectations.