Thursday, March 23, 2023

Who decided the target for inflation should be 2%?

Central banks around the world have been extremely active in recent months raising interest rates in order to reduce inflation from levels approaching double figures down to the generally agreed target rate of 2%. But who decided that 2% should be the target? Why not 3% or 4% (or 0%)?

The Bank of Canada website attempts to explain it for the lay person. After the high rates of the 1970s and 80s, when inflation peaked at around 12% in Canada, the BoC reacted strongly and managed to wrestle the inflation rate down to 2% by the mid-90s, and it concluded then that "this target resulted in good overall economic performance". They then kept inflation low for the best part of three decades - in fact, up until the perfect storm that was 2022 - because "in our experience, inflation tends to be close to the 2% target when the economy is running near its capacity - when demand for goods and services is roughly equal to what the economy supplies".

In practice, the BoC would be happy with inflation anywhere between 1% and 3%. But if it strays too far from that target, then the BoC knows from past experience that the economy is out of whack and running sub-optimally, so it acts. 

That said, the 2% target is still to some extent an arbitrary figure, apparently first established by New Zealand in the late 80s. But it has adopted by so many other countries since then (Canada, USA, Israel, Australia, Japan, among others), that it has become an article of faith. And, in the absence of evidence to the contrary, there is no reason to second guess it now.

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