7 min read

Where Does The 2% Inflation Target Come From Anyway?

Would you rather have greater purchasing power, or "output that is close to the economy's maximum sustainable level of output"?
Where Does The 2% Inflation Target Come From Anyway?

Many Western economies are aligned around the idea that "low and stable" inflation of around two percent is ideal. Today's central bankers have vividly in their minds the painful memory of runaway inflation of the 1970s and 1980s. Having tamed excess inflation and learned to steer economies from running too hot or too cold with judicious raising and lowering of interest rates, almost no one questions the wisdom of central bank mandates.

Here's how one of the Members of the Board of Governors of the US Federal Reserve System (Laurence Meyers) described central bankers' thinking in remarks from July 2001:

There is widespread agreement that price stability (in practice, low and stable inflation) should be an objective of monetary policy.

Already 20 years ago, it was taken as established wisdom that price stability was an appropriate goal for central bankers. As to what price stability means, Mr. Meyers continued, quoting Alan Greenspan:

We will be at price stability when households and businesses need not factor expectations of changes in the average level of prices into their decisions.

Note the casual lumping together of households and businesses in this description. Is it clear to you that businesses and households behave the same ways in inflationary and deflationary environments?

More importantly, do low positive inflation and low negative deflation have the same impact on expectations? For individuals who spend most of what they earn in the near term, probably. After all, you still need to buy food and heat your home, whether prices are rising slightly, or falling. There is a point at which large changes in price will affect your decisions on buying discretionary items, or the timing of when you buy an item, but positive or negative two percent is probably not going to influence many decisions.

So if you don't mind a little deflation, who does? Well, businesses and governments who borrow to fund their operations, for example because they spend more than they make in a given period (i.e. who run a deficit), would much prefer to have positive inflation. Why is that, you ask? Inflation reduces the value of what you owe over time. If you are able to borrow permanently, for example by rolling over your debt with new debt each time the existing debt comes due, then you would prefer to have your debt become worth less every year, which is what inflation does.

Later in his remarks, Mr. Meyer gives the game away, or at least hints at it, when he notes:

The Fed sometimes prefers to state its objective simply as promoting maximum sustainable growth. Low and stable inflation ("price stability") is essential to good macroeconomic performance and hence should be an objective of macroeconomic policy.

The Fed is seeking to promote "maximum sustainable growth" of the economy, in other words, growth in GDP. Look how smoothly policymakers glide past the potentially differing preferences of individuals, businesses, and policymakers:

Households and businesses are presumed to prefer low and stable inflation to high and variable inflation. But they also prefer high and rising real income per capita and output that is consistently close to the economy's maximum sustainable level of output.

First, note again the joining of households and businesses, which may have different preferences at different times. To give the obvious examples: business wants to charge maximum prices and pay employees minimum wages. Employees want low prices and maximum wages. What's another way to achieve rising real income at an individual level? Deflation. That is, if your income stays the same and prices decrease, your purchasing power has increased. Would you rather have greater purchasing power, or "output that is close to the economy's maximum sustainable level of output"?

So to sum up, it seems a good argument can be made that on an individual level, we would prefer prices to be flat or slightly decreasing over time. There comes a point at which excesses in either direction will harm the broader economy. This, in turn, will harm individuals when businesses adjust with layoffs and/or larger price increases. But within the band of potential "low and stable" rates, policymakers have uniformly agreed on positive inflation as being good for GDP growth.

The Bank of Canada puts it this way:

We target inflation because a low, stable and predictable rate of inflation is good for the economy.... Average economic growth is stronger, and employment is higher.

The Bank of Canada also gives the game away, however, when they say not that two percent inflation is the rate individuals would prefer, but the rate that seems to coincide with maximum economic growth:

In our experience, inflation tends to be close to the 2 percent target when the economy is running near its capacity—when demand for goods and services is roughly equal to what the economy supplies.

The Reserve Bank of Australia makes a gratuitous reference to the "welfare of the Australian people" but still expresses its target in terms of economic growth:

The Reserve Bank uses an inflation target to help achieve its goals of price stability, full employment, and prosperity and welfare of the Australian people. This is because price stability – which means low and stable inflation – contributes to sustainable economic growth.

The Bank of England describes their mandate as follows:

To keep inflation low and stable, the Government sets us an inflation target of 2%. This helps everyone plan for the future. If inflation is too high or it moves around a lot, it’s hard for businesses to set the right prices and for people to plan their spending. But if inflation is too low, or negative, then some people may put off spending because they expect prices to fall. Although lower prices sounds like a good thing, if everybody reduced their spending then companies could fail and people might lose their jobs.

In its deflation reference linked above with the scary words "people might lose their jobs," the Bank of England gives an example of ten percent deflation potentially affecting your purchase of a new bike. I'll give them credit for at least putting a number on the type of buying decisions that could be affected by deflation. But is this example representative of most people's expenditures, or does it leave a misleading impression? (I will return to this in a moment below.)

Coming back to the U.S., the Federal Reserve has made it a little harder for the average person to follow their argument when they describe the purpose behind their 2% inflation target:

The Federal Open Market Committee (FOMC) judges that inflation of 2 percent over the longer run, as measured by the annual change in the price index for personal consumption expenditures, is most consistent with the Federal Reserve’s mandate for maximum employment and price stability.

Nowhere in the Federal Reserve's mandate do you see anything about the preferences of individuals. They do note that inflation has an impact on individuals:

It is understandable that higher prices for essential items, such as food, gasoline, and shelter, add to the burdens faced by many families, especially those struggling with lost jobs and incomes.

Really? Inflation causes prices of all items to increase, not just essential items. Even with this disingenuous remark, the Federal Reserve immediately continues by raising the concern that low inflation can harm the economy and economic growth.

At the same time, inflation that is too low can weaken the economy. When inflation runs well below its desired level, households and businesses will come to expect this over time, pushing expectations for inflation in the future below the Federal Reserve’s longer-run inflation goal.

Nowhere defined is what inflation running "well below its desired level." Is it 10% deflation, as implied by the Bank of England? And keeping in mind the character of "essential items" that the central banks like to talk about (and exclude from their figures when it suits them), individuals continue to consume essential items regardless of price changes, up or down. That's why they're called essential. You will continue to eat and heat your home this month, even though you suspect prices will go down next month.

You can decide for yourself which of the categories of consumer expenditures you'd be willing to do without over long periods of time. I suppose we could put off purchasing a new or used vehicle (7% of the total), or we could buy less clothes, alcohol, and tobacco (4%). But will you give up food, energy, shelter, and medical services, which together make up more than 60% of the Consumer Price Index?

All of this is simply to say that central banks are using a tenuous argument when they try to justify their inflation targets as being beneficial to individuals. In fact, central banks are really rather transparent in saying their overarching goal is GDP growth and keeping economies at full capacity.

I suggested one possible explanation for this approach above. That is, most countries and businesses maintain large and permanent amounts of debt. Inflation helps reduce the relative debt burden over time.

But a more important question might be, "Do our economies have to be run this way?" Ah, that is an entirely different question. It goes to an even more fundamental topic. Who said GDP growth is the best measure of a country's progress, anyway, and why?

I will return to that topic later this week. In the meantime, perhaps you will spend a few minutes asking yourself what you are looking for in life. Is it to have stuff, or is it to be happy? I know you may have thought that having stuff was a way to become happy, but by now you know that possessions as a path to satisfaction is not at all assured.

At this point, are you sure you know what will make you happy? And are you equally confident that your politicians and central bankers do?

Be well.

PS – After I wrote this, I came across a refreshingly direct research paper from no less than an economist working for the Federal Reserve Board. Jeremy Rudd's recent paper is called "Why Do We Think That Inflation Expectations Matter for Inflation? (And Should We?)". I'll leave it for you to explore his thoughts if you're interested. He writes well, and the paper is also entertaining. He starts with this introduction:

Mainstream economics is replete with ideas that "everyone knows" to be true, but that are actually arrant nonsense.

For our purposes, it is sufficient to note that at least some experts within one important central bank are starting to question the common wisdom about inflation. It would be nice to see more of this questioning attitude.