Why is 2% the central bank inflation target?

The 2% central bank inflation target has been a cornerstone of monetary policy in many developed countries since the 1990s. It is a key tool used by central banks to achieve price stability and promote economic growth.

History of the 2% inflation target

The idea of targeting inflation as a monetary policy goal began as a response to high inflation rates in many developed countries. The goal was to achieve price stability by keeping inflation low and stable. The first central bank to adopt an explicit inflation target was the Reserve Bank of New Zealand. Other central banks followed suit, including the Bank of Canada , the Bank of England, and the European Central Bank. The US Federal Reserve also has an inflation target as part of their mandate, alongside their goal of maintaining full employment.

The 2% inflation target has become the de facto standard among many central banks. The target was chosen because it was believed to be low enough to prevent inflation from becoming a problem but high enough to avoid deflation, which can be harmful to economic growth. The 2% target is also seen as a compromise between the preferences of creditors (who prefer lower inflation) and debtors (who prefer higher inflation). There is also an argument that nominal increases are good for morale, i.e. if you salary goes up 2%pa then that feels like progress, even if it does not buy more.

Relevance of the 2% inflation target today

In recent years, there has been some debate about the relevance of the 2% inflation target. Critics argue that the target is too low and that central banks should aim for higher inflation rates to stimulate economic growth. They point out that low inflation rates may lead to deflationary pressures, which can be harmful to the economy.

Proponents of the 2% target argue that it has been effective in achieving price stability and that there is no evidence that higher inflation rates would lead to stronger economic growth. They also argue that higher inflation rates could lead to higher interest rates, which could be harmful to economic growth.

Another factor that has led to some questioning of the 2% target is the changing nature of the global economy. With the rise of globalization and increased competition, some argue that it may be more difficult to achieve price stability and that the 2% target may be too ambitious in this context. 

Developed market inflation was close to 2% for much of the pre-Covid decade, but it has been markedly higher since the pandemic. Higher inflation can change the expected returns and correlations for different asset classes, but it is hard to know whether these will recalibrate if expected inflation is shifted higher thanks to an increased target.

Future direction of the 2% inflation target

The future direction of the 2% inflation target is unclear. There has also been some discussion of adopting a more flexible inflation target. This could involve targeting a range of inflation rates rather than a specific number.

A more flexible target would allow central banks to respond to changing economic conditions while still maintaining price stability . It is perhaps unlikely that a central bank will implement a direct like-for-like change to the target, switching from 2% to 3% say, but perhaps more likely that they would change the measure of inflation that they focus on, or the timeframe over which they seek to reach their goal. The US Federal Reserve has already said that they will focus on the rate of inflation ‘through the cycle’.

In some cases, central banks have begun to pay greater attention to net zero targets and climate impact. It may be that they look to broaden their mandates further to include climate-related goals, which may reduce their focus on inflation.

Conclusion

The 2% central bank inflation target has been a key tool in monetary policy for many developed countries since the 1990s. While it has been effective in achieving price stability, there is debate about its relevance in today's changing global economy. The future direction of the target is unclear, but some central banks are already moving away from it or considering more flexible targets. As financial advisers, it is important to stay up to date on developments in monetary policy and to adjust investment strategies accordingly.