Across the world, central bankers are banding together to raise interest rates, deliberately slowing down their economies even in the face of an epic shock to meet a specific target: 2 percent inflation.
“Let me be quite clear, there are no ifs or buts in our commitment to the 2 percent inflation target,” Bank of England Governor Andrew Bailey said in a July speech. “That’s our job, and that’s what we will do.”
This specific commitment is shared in some form by the European Central Bank, the Federal Reserve, the Bank of England, the Reserve Bank of Australia, the Bank of Canada, the Bank of Japan, the Swedish Riksbank, the Bank of Korea and the Czech National Bank. Together, these central banks oversee the monetary policy of economies that make up almost half the world’s economic output.
Now, facing dramatic increases in energy prices that are taking a hammer to economic growth around the world, especially in Europe, many of these countries are using a tool developed in New Zealand in the late 1980s. New Zealand’s target of zero to 2 percent inflation became a standard for the rest of the world.
It’s something of an arbitrary number — and economists the world over have been debating it more or less since it was introduced. While central banks in countries experiencing high inflation are all trying to bring it down as inflation cools, the debate over the appropriate target could heat up again.
The world’s current inflation crisis, the worst in 40 years, is testing central banks’ commitments to their targets as the process of lowering inflation takes a toll on other aspects of the economy. In Britain, the nation’s central banker is predicting a downturn that could last years, and the Federal Reserve has forecast a rise in the unemployment rate that could increase the ranks of the unemployed by over one million as it cranks up interest rates to combat inflation, even at the risk of a global recession.
“For the first time in four decades, central banks need to prove how determined they are to protect price stability,” European Central Bank executive board member Isabel Schnabel said in an August speech.
So, why 2 percent?
By the end of the 1980s, New Zealand’s reformist Labour government, which had taken power in the middle of the decade, was making some progress in bringing down inflation, which had been above 10 percent for much of the decade.
The idea of formalizing a precise target came from New Zealand’s minister of finance Roger Douglas in the 1980s, who said in a TV interview that inflation should be between zero and 1 percent. While inflation had fallen, policymakers in New Zealand worried that the public would expect their inflation-fighting program to slacken.
“Douglas was very concerned in March 1988 that, with inflation moving into single figures … the public would expect the monetary authorities to ease up and settle for inflation in the 5 to 7 percent range,” Don Brash, former governor of the Reserve Bank of New Zealand, told Grid, and thus made the almost offhand declaration that his goal was essentially no inflation.
Implementing the target fell on Brash. In 1989, New Zealand’s parliament gave the Reserve Bank of New Zealand independence to operate as it saw fit but do so with the target the government decided upon. Early the following year, the government implemented an agreement with Brash to hit the zero to 2 percent target by the end of 1992. Brash recalled feeling surprised that the contract was with the governor personally and not the bank. But he soon got the message: While the government couldn’t fire the bank for failing to fulfill the agreement, it could fire him.
That marked the “kind of curious,” origin of the inflation target, according to Brash. The initial target, as even its proponents admit, is a bit of guess work — a combination of impromptu rectitude and statistical analysis.
While the conservative Brash is the figure most associated with the idea of announcing a target, it was just one of many policies implemented by the ostensibly left-wing government under the leadership of Finance Minister Roger Douglas, whose efforts to overhaul the economy were known as “Rogernomics.” This program was one of the most ambitious and far-reaching episodes of free-market reform in the 1980s, even compared with those championed by conservative leaders like Reagan and then-British prime minister Margaret Thatcher.
Like with Reagan and Thatcher’s reforms, subsequent governments have been unable to roll back much of what the Labour government accomplished, including inflation targeting, even if the policy itself was something of an improvisation.
As former Federal Reserve economist Joe Gagnon put it to Grid, there’s broad consensus that 10 percent inflation, the kind suffered in New Zealand in the 1980s and the United States — is bad. But why is 2 percent ideal?
After all, even the sainted Paul Volcker, former chairman of the Federal Reserve — who wrested the United States out of hyperinflation in the early 1980s, a decade before Brash — could only get inflation to around 4 percent. “There was not any serious study of what the optimal target was at first,” Gagnon said. “Anything between zero and 5, it was hard to tell the difference, and things below zero were not good. Best you could say was [between] zero and 5.”
And while inflation targets are still in place, they’re not set in stone. New Zealand’s target has moved from between zero and 2 percent to between 1 and 3 percent. The United States itself, while well above the target now, announced in August 2020 what is known as “average inflation targeting,” where inflation is permitted to rise above 2 percent in order to make up for periods when it was below 2 percent.
Implementing an offhand comment
With the target, New Zealand’s inflation rate fell, although Brash is quick to observe that he does not take all the credit for it. The Labour government had pursued what would be called a neoliberal agenda of income tax cuts, privatizing government enterprises, allowing the New Zealand dollar to trade freely on international markets and scrapping agricultural subsidies.
“This so-called Labour government was the most Thatcherite-Reaganite government that New Zealand had never seen or seen ever since,” Brash said. “The extent of the reform in tax, tariffs and imports control was breathtaking. ...They were ruthlessly determined to implement radical policy.”
But Brash is not entirely willing to redirect credit for New Zealand’s economic reforms. He claims the zero to 2 percent target, and all the publicity around it, helped change the mindset of New Zealand’s businesses, citizens and especially labor unions about how prices would change over time.
New Zealand, Brash pointed out, is a small country compared with the United States. “You can go around and talk to rotary church groups and farmer groups,” he said. “You can make it clear you don’t give a fig about unemployment [rising], you will get inflation down by hell or high water.” And unemployment did rise as high as 11 percent in 1991.
When inflation is volatile, there is often labor unrest as workers demand their wages keep pace with rising prices and then that they don’t fall. The “Volcker Shock” of the 1980s — when Volcker wrenched inflation down from over 10 percent to 4 percent at the cost of two recessions — was, in Volcker’s eyes, aided by then-president Ronald Reagan’s decision to fire striking air traffic controllers in 1981. Reagan’s decision, while it only affected around 12,000 workers, was seen by many — including Volcker — as the federal government breaking the back of organized labor in the United States. “The significance [of breaking the strike] was that someone finally took on an aggressive, well-organized union and said no,” Volcker told a biographer. “I think that did have a psychological effect on the strength of the union bargaining position on other issues.”
In New Zealand, things were a bit less brutal. The inflation target helped the Labour government convince the trade unions to exercise what is known as “wage restraint.”
While New Zealand would, under a conservative government elected in late 1990s, radically overhaul its labor market institutions, in Brash’s telling, the 2 percent target had a moderating effect on organized labor — and one that worked out under the governance of labor’s ostensible allies. New Zealand’s trade union leader, Ken Douglas, agreed to advocate for wage increases in line with the government’s inflation target. Brash praised the agreement between the unions and the government to keep wage growth in employment contracts at 2 percent.
But the target also gave the bank the tools to discipline the government in concert with investors. After the Labour government released a budget in the summer of 1990 that struck the Reserve Bank of New Zealand as unduly loose, it tightened monetary policy after investors sold off New Zealand government bonds and its currency (followers of British news may find this familiar). In its official policy statement, the bank said that “the underlying fiscal position evident in the budget was disappointing to financial markets, and appears to have given rise to new concerns about the direction of policy.”
New Zealand would eventually hit the target in 1992, and the idea of inflation targeting would be firmly anchored in both New Zealand and around the world in the 1990s, with Australia, New Zealand, Canada and the United Kingdom adopting some form of inflation targeting between 1991 and 1993 — often as part of a suite of economic reforms in response to previous economic turmoil.
The world’s most important central bank came on board — sort of — in the mid-1990s. While inflation targeting had been brought up in Federal Reserve meetings at early as 1989, the conversation really heated up in 1995, when during an internal debate, economist Janet Yellen, before she became chairwoman of the Federal Reserve, opposed the targeting proposal, and again the next year.
The Fed then agreed on a target — but never disclosed it. “[Then-chairman of the Federal Reserve Alan] Greenspan had a view you shouldn’t talk about what you’re doing and you should be secretive and mysterious,” Gagnon said.
While Greenspan managed to get inflation down below 2 percent, he did not do so using a public target, which would allow for the kind of accountability that’s a key feature of inflation targeting systems used in other countries. Typically, the elected government comes up with the target and gives the central bank the freedom to achieve it.
With Greenspan, things were a little looser. The 2 percent figure was something of an improvisation. In the 1996 Federal Reserve meeting where several scholars agreed upon a target, Greenspan mused that something like zero inflation should be the goal, saying that “price stability is that state in which expected changes in the general price level do not effectively alter business or household decisions.” When Yellen asked him to define what he meant, he clarified, “I would say the number is zero, if inflation is properly measured.”
“Improperly measured, I believe that heading toward 2 percent inflation would be a good idea, and that we should do so in a slow fashion, looking at what happens along the way,” Yellen responded, and Greenspan soon moved on.
The “improperly measured” issue refers to the idea that inflation numbers have an “upward bias,” that the reported inflation figure is actually a little higher than the “real” change in prices. These calculations, while informal, were not too far off from what was happening in New Zealand when the inflation target was born. “We figured zero to 2 was tantamount to actual price stability plus or minus one, that was the way we rationalized it internally: price stability plus or minus one,” Brash told Grid.
By 1997, two monetary policy scholars felt confident enough to say that the Fed “employed a policymaking philosophy, or framework, which is de facto very similar to inflation targeting.” One of these scholars was an economist at the New York branch of the Federal Reserve, the other was future Chairman of the Federal Reserve Ben Bernanke.
Inflation targeting in the United States
The Federal Reserve formally adopt a 2 percent target in 2012 under Bernanke. The Fed, unlike some other central banks, has a pair of mandates from Congress: stable prices and maximum employment. Frank worried, Bernanke wrote, that by adopting a formal target for inflation, the Fed would be implicitly saying it cared less about the employment portion of the mandate. Considering that over 2 million jobs would be lost in the first quarter of 2009, Frank might have had a point.
And this was hardly a new argument in central banking circles — Yellen had raised it in the mid-1990s in her first stint on the Fed.
When the target was announced in 2012, there was no apparent conflict between hitting the target and unemployment, as inflation was below 2 percent and unemployment was above 8 percent.
In the 2010s, the debate over the 2 percent target intensified, with a number of economists that central bankers pay attention to — including former Treasury Secretary Larry Summers and former International Monetary Fund chief economist Olivier Blanchard — calling for a higher target. Gagnon, one of those voices, said there is still debate over the wisdom of the 2 percent target. “I have heard very senior [former] central bankers say the 2 percent target was a mistake and they wish they haven’t chosen it,” Gagnon said. “They kind of feel trapped.”
While the battle that central bankers won in the 1980s and 1990s was getting permission from their governments to hack away at inflation at the cost of higher unemployment with the hope of both of them eventually settling at a low level, the challenge of the first two decades of the 21st century was unemployment running too high while inflation was too low.
This effect was especially pronounced after economic crises like the one Japan faced in the 1990s or the United States (and much of the world) did in the late 2000s. When economies seize up, central banks tend to cut interest rates in order to stimulate economic activity. But there’s only so low they can go: zero. When inflation is already low and interest rates are low — which is, after all, the point of the policy — there is only so much juice you get from cutting rates.
When inflation is higher, say 3 or 4 percent, interest rates can be higher too, meaning there’s more scope to cut during a crisis. “If inflation were higher … then interest rates would be 1 or 2 percent higher,” Gagnon told Grid. “It would make a big difference if we had 1 percent more inflation.”
These concerns were largely dismissed as unlikely or not particularly serious by many economists, including at the Fed itself. Forced up against zero interest rates, central banks around the world found themselves resorting to massive quantitative easing programs following the Great Recession and years of sustained high unemployment.
“Boy, were they wrong,” Gagnon said.
While theoretically this approach was symmetrical — inflation could go below 2 percent to make up for above average inflation. In practice, Gagnon argues, it was understood as primarily operating as a method to allow for higher than 2 percent inflation. “It was an admission that 2 percent was too low and got us stuck at zero bound,” Gagnon said. “They were casting about for a way to relax that restraint without abandoning the 2 percent target.”
But those days are gone — at least for now. The Fed today is squarely focused on bringing down inflation, even at the cost of higher unemployment and slower wage growth for workers. But the old inflation target debate could rear its head. For one, the Fed doesn’t seem to have much, if any, appetite for bringing inflation below 2 percent. Instead, as Federal Reserve Chairman Jerome Powell said in his press conference last week, “The [Federal Open Market Committee] is strongly resolved to bring inflation down to 2 percent, and we will keep at it until the job is done.”
But, Gagnon sees some room for relaxing if inflation falls off its blistering pace but doesn’t get quite down to 2 percent.
“Imagine a year or two from now, the economy has slowed down and we have a mild recession and even more unemployment, and inflation has come down to 3 to 4 percent. Should the Fed keep interest rates high and wring all that last little bit of inflation out of the economy at the cost of even more unemployment and a longer recession — or should it settle at 3, relax, and then raise the target?” Gagnon said.
“That’s what I would recommend,” he said, adding, “I won’t be surprised if that happens.”
An earlier version of this article misstated when Ben Bernanke was chairman of the Federal Reserve. This version has been corrected.
Thanks to Alicia Benjamin for copy editing this article.