This video explains why many central banks, including those in the G7 nations, target a 2% inflation rate. It details the surprising and somewhat arbitrary origin of this target in New Zealand in 1989 and discusses the justifications economists use for maintaining a low, positive inflation rate, such as giving central banks more room for monetary policy and avoiding deflation. The video also explores the negative consequences of deflation, like reduced economic activity and increased debt burden, and addresses criticisms of inflation targeting.
Key Takeaways
1
Many countries, including the G7 nations and the Euro area, currently target a 2% annual inflation rate.
2
The 2% inflation target originated arbitrarily in New Zealand in 1989, where it was initially set as a range of 0-2% inflation.
3
Communicating an inflation target helps central banks achieve their goals by anchoring inflation expectations among market participants, influencing their behavior.
4
A 2% inflation rate is considered low enough to not significantly impact purchasing power in the short term, but still allows central banks more room to cut interest rates to stimulate the economy when needed.
5
Positive inflation can make it easier for companies to reduce real wages through stagnant pay, helping the economy stabilize during recessions without resorting to layoffs.
6
Targeting 2% inflation helps avoid deflation, which is feared by economists for its potential to reduce economic activity by incentivizing saving over spending and creating deflationary spirals.
7
Deflation can make it harder to accumulate money, increase the real burden of outstanding debts, and lead to falling real incomes and rising unemployment.
8
One major issue with positive inflation targeting is that wages and savings rates do not always keep pace with inflation, leading to a decrease in real income and purchasing power for households.
9
Changing the established 2% inflation target is difficult because central bank credibility, a key component of inflation targeting's effectiveness, could be negatively impacted.
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0:14
the plain bagel. The idea of countries
0:16
targeting a given inflation rate is
0:18
something that most of us take for
0:19
granted when discussing central bank
0:21
policies. After all, many countries,
0:23
including here in Canada and the United
0:25
States, task their central banks with
0:27
maintaining price stability. So it makes
0:29
sense that they establish some sort of
0:31
public goal for guiding their monetary
0:33
policy and tracking their progress. And
0:35
today we have roughly 45 individual
0:37
countries and the entire Euro area
0:40
establishing some sort of public
0:42
inflation target with many including all
0:44
of the G7 nations, the Euro zone, and
0:46
even just recently China opting for a 2%
0:50
target, meaning that every year they
0:51
look to have their price levels increase
0:53
by 2%.
0:56
But why? After all, it's obvious that a
0:58
2% inflation rate would be better than
1:00
say 100%. It might still sound a bit
1:02
arbitrary or even backwards. If the
1:04
central bank's objective is to maintain
1:06
price stability,
1:08
why not target 0% inflation? Or heck,
1:11
why not try to lower prices so that
1:13
households can actually afford more
1:14
goods over time with their savings put
1:17
aside? Well, the truth is that the
1:19
origin of this 2% target is in fact
1:22
pretty arbitrary and probably a lot more
1:26
recent than you might otherwise expect.
1:27
In fact, the first country to implement
1:29
an inflation target, New Zealand, only
1:31
did so 36 years ago. And the US Federal
1:34
Reserve, didn't have an explicit
1:36
inflation target until 1996.
1:39
And even then, the target was only made
1:40
public starting in 2012. And yet,
1:43
despite all this, it's quickly become
1:45
part of central bank dogma with Japan up
1:47
until recently even pushing to get its
1:49
inflation rate up to 2% after years of
1:52
stagnant and falling prices. So, what's
1:54
so special about this 2% rate? Well,
1:56
today we'll talk about the bizarre
1:58
origin of this figure, why it's been
2:00
maintained, and the justifications for
2:01
targeting any inflation at all, the
2:04
arguments against such a target, and how
2:06
these policies ultimately impact the
2:08
economy as a whole. But to start things
2:10
off, let's start again with that origin
2:12
of this figure back in New Zealand. You
2:14
see, in 1989, as the world was still
2:16
grappling with fairly high inflation
2:18
rates, we saw the country who itself was
2:19
dealing with years of double-digit
2:21
inflation pass a bill that sought to
2:23
make its central bank independent from
2:25
the government to allow to freely pursue
2:27
monetary policy. And while not the focus
2:29
of the legislation, the bill also
2:30
instructed the finance minister and the
2:32
head of the central bank to establish an
2:34
inflation target with the country
2:36
ultimately settling on a target range of
2:38
0 to 2% inflation every year. And as for
2:41
how we arrived to this figure that would
2:42
forever shape monetary policy moving
2:44
forward, well, seemingly a TV interview.
2:48
You see, a year earlier, the previous
2:49
finance minister, Roger Douglas, in an
2:51
interview highlighted that he would like
2:53
to target inflation of between zero and
2:55
1% uh before this legislation had been
2:58
passed. And allegedly, the country just
3:00
kind of went with that with the central
3:01
bank and the finance minister increasing
3:03
the upper bound to 2% to allow for a bit
3:06
more flexibility.
3:07
That's it. This monumentally important
3:10
figure was effectively pulled out of
3:12
thin air. So, yeah, not much of a robust
3:14
or empirical process for getting to this
3:16
figure. But what's interesting about
3:18
this policy is that it seemingly worked.
3:22
Inflation dropped from its double-digit
3:23
range in the late 1980s to within its
3:26
target range after just a few years with
3:28
economists finding that by communicating
3:30
an inflation rate to the economy, it
3:32
actually helped central banks achieve
3:34
this objective by influencing expected
3:37
inflation. You see, if a central bank is
3:39
viewed as credible and independent by
3:41
market participants, then communicating
3:43
an inflation target helps to anchor
3:45
inflation expectations, which influences
3:48
the behavior of those market
3:49
participants. Banks will assume a 2%
3:51
interest rate when they make their
3:52
loans. Unions will bargain for a 2%
3:54
annual increase to ensure that salaries
3:56
keep up with that expected inflation
3:58
rate. And these actions in and of
3:59
themselves lead inflation to becoming
4:02
that 2%. So despite the experimental
4:05
nature of this regime, it quickly gained
4:06
traction among many developed nations.
4:08
And despite there being not much of an
4:10
empirical process behind it, there were
4:12
still some key arguments supporting the
4:14
idea of targeting a low positive
4:16
inflation rate that are still used to
4:18
the state to justify the figure.
4:19
Firstly, 2% is viewed as being low
4:21
enough as to not materially impact the
4:23
purchasing power of the dollar from year
4:25
to year. Yes, of course, any money that
4:27
you stow under your mattress for the
4:28
long term is going to see its purchasing
4:30
power fall quite a bit over your
4:32
lifetime. Even at a 2% inflation rate, a
4:34
dollar today loses half of its value
4:36
over 35 years. But in the short term,
4:38
it's viewed as having a minimal impact
4:40
on the dollar store value. Secondly,
4:42
having an inflation target above 0%
4:44
gives central banks more room to carry
4:46
out monetary policy. Uh you see,
4:49
inflation rates have a direct impact on
4:51
interest rates charged in an economy. uh
4:53
because naturally if the money you lend
4:56
out to people is losing value over time,
4:58
you're going to want to be compensated
4:59
for that lost value when that amount
5:02
when that loan is eventually paid back
5:03
to you. So lenders will directly
5:05
increase the interest rates they charge
5:07
based on expected inflation rates. So
5:09
the higher the central bank's targeted
5:10
inflation rate, the higher interest
5:12
rates in the economy should be. And
5:14
having higher interest rates give
5:15
central banks more room to cut set
5:17
interest rates to stimulate the economy
5:20
given that 0% sort of stands as a lower
5:22
bound. Yes, we've seen examples of
5:24
negative interest rates, but for the
5:26
most part, 0% is the least you can
5:28
charge on lent money. So, by targeting a
5:30
higher inflation rate, central banks can
5:32
have a larger impact on the economy if
5:34
they expect a recession or severe
5:36
contraction. And another aspect as well
5:38
with all of this is that a positive
5:40
inflation rate makes it easier for
5:41
companies to reduce real wages of their
5:44
employees in response to economic
5:46
shocks. Now, I know what you're
5:47
thinking. Richard, what the hell? Why
5:49
are we making it easier for companies to
5:51
cut our incomes? That uh sounds like a
5:54
conspiracy to screw over workers. And
5:56
we'll get into the shortcomings of this
5:57
philosophy in a moment. But the point is
5:59
that when an economy sees demand fall
6:01
during a recession, for economies to
6:03
stabilize themselves, companies
6:05
theoretically should be able to reduce
6:07
wages, lay off employees, and ultimately
6:09
lower their prices to allow the economy
6:11
to return to its full GDP potential. The
6:13
problem is that in practice, wage cuts
6:15
are actually pretty rare with companies
6:17
instead opting to just laying off
6:19
employees when they need to reduce their
6:21
labor costs. But with a positive
6:22
inflation rate, companies can keep wages
6:24
stagnant, thereby effectively cutting
6:26
the wages in real terms and allowing
6:28
economic activity to normalize and reach
6:30
that point of equilibrium with the same
6:32
principle applying to interest rates,
6:33
which can dip into negative territory in
6:36
real terms when there's positive
6:38
inflation. And finally, the last
6:39
justification for why central banks
6:41
target a 2% inflation rate is that it's
6:43
viewed as being high enough to avoid
6:45
deflation or price levels decreasing
6:47
over time. Uh since inflation often
6:49
deviates from the central bank's target
6:51
in any given year, the higher the
6:53
target, the less likely it is for price
6:54
levels to dip into deflation territory.
6:57
Now, that does bring us to a question
6:58
that many find quite frustrating. Why do
7:01
economists treat deflation like the
7:04
boogeyman? After all, it sounds like a
7:05
good deal. Who wouldn't want prices to
7:07
fall every year to reward them for
7:10
putting money aside? All this just kind
7:12
of sounds like an excuse for the
7:13
government to inflate their currency.
7:15
Well, there is certainly that
7:16
consideration. And Milton Friedman, a
7:17
famous economist, once called inflation
7:19
taxes without legislation, which is a
7:22
pretty fair assessment. Inflation is
7:24
fueled by government spending at the
7:25
expense of household wealth. But the
7:27
general concern is that while yes,
7:29
deflation could be beneficial for the
7:31
households that have meaningful savings
7:33
put aside, it does come with a number of
7:35
other consequences. uh the main one
7:37
being that deflation is thought to
7:38
reduce economic activity by just doing
7:42
that incentivizing individuals to save
7:44
their money rather than spending it.
7:46
After all, if the car or dishwasher that
7:48
you want to buy is going to be cheaper a
7:49
year from now or even 2 or 3 years down
7:51
the line, then it's going to incentivize
7:53
people to put off that purchase until
7:55
it's absolutely needed. Compared to
7:57
inflation, which incentivizes people to
7:58
spend their money now and boost economic
8:00
activity, economists also fears
8:02
something called deflationary spiral. As
8:04
prices fall, companies are faced with
8:06
lower profits, which leads them to cut
8:08
costs by cutting jobs and lowering
8:10
wages, which leads to less spending and
8:12
investing in the economy, which brings
8:13
us back to more deflation and continues
8:16
the vicious cycle. Something that can
8:17
ultimately end in a severe economic
8:19
contraction that can prove difficult to
8:21
pull out of with monetary policy given
8:23
again the lower bound on interest rates.
8:25
something we've seen in countries like
8:26
Japan, which experienced the so-called
8:28
lost decade in the 1990s, where crash in
8:31
its stock and real estate market was
8:32
followed by a decade of sluggish
8:34
performance and low inflation or even
8:37
deflation. And when we're sort of
8:38
assessing the pros and cons to the
8:40
economy as a whole rather than
8:41
individuals, you might have caught one
8:42
of the important implications for
8:44
households is that falling real income
8:47
as well as rising unemployment. So yes,
8:50
savings might become more valuable, but
8:51
it might get harder to accumulate any
8:53
money in the first place. So, while
8:54
deflation can be great for those who
8:56
already have money, it can make it
8:58
harder to accumulate and can even
9:00
increase the real burden of outstanding
9:02
debts. Because things like mortgage and
9:04
credit card balances have a fixed dollar
9:06
amount that you owe at the end of the
9:07
term, that amount is going to become
9:09
more and more valuable in real terms,
9:12
making it harder and harder to pay off,
9:14
especially if you face falling income,
9:16
which is important when you consider how
9:18
indebted many countries and their
9:19
households are in the current economic
9:21
environment. Now, of course, there's the
9:23
argument that inflation has incentivized
9:25
this debt accumulation over time. And
9:27
it's worth highlighting that not all
9:28
deflation is necessarily bad.
9:31
Technological innovation, for example,
9:33
frequently leads to productivity gains
9:35
and falling prices. And while deflation
9:37
can be a sign or trigger of falling
9:39
demand, we have seen periods of strong
9:42
economic growth coupled with falling
9:44
price levels due to increases in supply.
9:47
Again, possibly coming from
9:48
technological innovations. One research
9:50
paper by the National Bureau of Economic
9:52
Research, for example, highlights that
9:53
during the late 1800s, the global
9:55
economy saw both falling prices and
9:58
rapid economic expansion in the face of
10:00
the industrial revolution. With the
10:02
paper arguing that while the constrained
10:04
money supply from the gold standard
10:06
negatively impacted economic activity,
10:09
this was more than offset by the
10:10
positive impact of those technological
10:12
advancements. And one of the biggest
10:13
issues people have with positive
10:15
inflation targeting is that while
10:17
theoretically it shouldn't really matter
10:18
what this target is, given that you
10:20
should see incomes increase at the same
10:22
pace as inflation and savings rates at
10:25
bank accounts compensate for this lost
10:28
spending power. In practice, inflation
10:29
does not apply to all these areas
10:31
evenly. And you can see wages, for
10:33
example, fall behind despite price
10:35
levels continuing to increase. Even
10:37
measuring inflation and tracking the
10:39
progress of this 2% target has proven a
10:42
contentious thing. While central banks
10:44
often use the consumer price index or
10:46
some variant like the core consumer
10:47
price index to assess how closely they
10:49
are to their target, these indices don't
10:51
always capture the actual price
10:52
increases that households are
10:54
experiencing given that they don't
10:55
account for things like substitution
10:56
where households change their spending
10:58
behavior based on changing prices. So,
11:01
it's worth noting that not everyone
11:02
agrees with a 2% target. And there are
11:04
known costs to inflation. Beyond the
11:06
deterioration of savings, inflation also
11:07
comes with menu costs, meaning the costs
11:10
associated with companies having to
11:11
frequently change the price of their
11:13
goods. And inflation tends to impose a
11:15
higher tax burden on households given
11:18
that tax brackets aren't often indexed
11:20
to inflation. So, a higher nominal
11:22
household income leads to a higher
11:24
percentage tax rate even if real wages
11:26
aren't increasing. However, the problem
11:28
is that it's difficult to prove
11:29
empirically which targeting regime,
11:30
whether it be moderate inflation or even
11:33
deflation, would be optimal for economic
11:36
activity given that most persistently
11:38
deflationary economies existed before
11:40
the Second World War when data
11:42
collection wasn't to the same degree or
11:44
quality. In fact, one of the biggest
11:46
criticisms of schools of economic
11:47
thought that advocate for deflation is
11:49
that they don't have much empirical
11:50
evidence to support their arguments.
11:52
It's also difficult, of course, to
11:53
isolate the influence of inflation or
11:55
deflation on the economy outside of
11:57
extreme examples in whether these exist
11:59
as symptoms or causes of economic
12:02
activity. What is more broadly accepted,
12:04
however, is that it's the unexpected
12:06
inflation and deflation that tends to be
12:10
detrimental to economic activity uh
12:12
given that they tend to be more
12:13
disruptive to the equilibrium of the
12:16
market. And interestingly, there are
12:17
some economists who have advocated for
12:19
even higher inflation targeting.
12:20
Something highlighted by former Fed
12:22
chair Alan Blinder, who has highlighted
12:24
that some academics argue we should
12:26
increase the inflation rate with him
12:27
arguing that if we could go back in
12:29
time, a somewhat bigger inflation target
12:31
quote would have been a better choice.
12:33
However, one issue highlighted by the
12:35
economist and one reason we still have
12:36
2% inflation targeting despite the
12:39
arbitrary origin of it is that the fact
12:41
that this rate has already been set
12:43
makes it very difficult to now change.
12:45
Because a key component of inflation
12:47
targeting working is the credibility of
12:50
central banks. Something that changing a
12:52
long-term inflation rate could have a
12:54
negative impact on. So in a way, part of
12:56
the reason we have a 2% inflation target
12:58
from many of these developed nations is
13:01
inertia and the fact that now it's a
13:03
little difficult to change. Now that's
13:05
not to say inflation targeting methods
13:06
haven't changed over time. For example,
13:08
a paper by the Bank of International
13:09
Settlements found that while many
13:11
central banks for developed nations have
13:13
tightened their numerical inflation
13:14
targeting over time, uh moving from
13:16
targeting within a range to an explicit
13:18
figure, the time horizon for achieving
13:21
this objective and the focus on other
13:23
factors like employment has increased
13:25
over time. And there may come a day
13:26
where we see a meaningful shift in
13:28
inflation targeting. But as of today,
13:30
those are the arguments for why we have
13:32
2% inflation targeting. And it wasn't a
13:34
very empirical process to get to this
13:36
magical figure, but still some
13:37
meaningful arguments supporting and
13:39
justifying that targeting regime. But if
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you like the math side of these
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15:17
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15:19
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Why Central Banks Target 2% Inflation
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