Across the world, central banks have been vowing for almost two years to return inflation to the target rate of 2%. In practice, this has meant increasing interest rates – the cost of borrowing – in order to slow down economic activity. Today, the Bank of England decided to leave interest rates in the UK at 5.25%, their highest level since 2008.
There are almost 60 countries that officially have a 2% inflation target, including the US, UK, Japan and the eurozone, but where does this actually come from? It is perhaps the most important policy objective being pursued today; you would think there must be a slew of empirical support that justifies this chosen target. After all, the target matters a great deal. If it were, say 3% or 4%, we would probably no longer be so concerned with rising prices, as many countries’ inflation has fallen to those levels.
I have spent hundreds of hours over the last few years poring over papers and documents at various central banks, going back decades, looking for some sort of document that would justify, or at least explain, the choice of a 2% target. I have not been able to find anything.
Now, I am not a fan of the 2% inflation target to begin with, as I am not convinced that inflation is “always and everywhere” a monetary phenomenon, to quote Milton Friedman – by which he meant that inflation is always about too much money in the economy. As such, I don’t think interest rates help much. I also believe that focusing on an inflation target detracts from the importance of fighting unemployment (or underemployment and low pay), which is, in my opinion, a greater problem than inflation.
But let’s focus on the choice of a 2% target. After the high inflation of the late 1970s and early 1980s, when it reached over 20% in the UK, central banks were left scrambling to find some new theoretical model to deal with rising prices. The first central bank to propose an inflation target of 2% was in New Zealand. But where did they get it from? Apparently, from thin air.
Recently, I came across this one story that suggested the choice of 2% was the result of an off the cuff remark in 1988 by the then New Zealand finance minister during a TV interview, who told reporters he would be happy with an inflation between 0% and 1%. This led the governor of the central bank at the time, Don Brash, to factor in an inflation bias of roughly 1% to arrive at the magical number of 2%. Michael Reddell, a colleague of Brash’s at the time at the Reserve Bank, admitted: “It wasn’t ruthlessly scientific.” Brash himself admitted as much: “It was almost a chance remark. The figure was plucked out of the air to influence the public’s expectations.”
A similar version of the events was proposed, in June 2023, by the Council on Foreign Relations, which concluded that “surprisingly [a 2% target] came not from any academic study”, and that it came about “somewhat accidentally”. Recently, Nobel prizewinning economist Joe Stiglitz arrived at the same conclusion: “Moreover, one must remember that the 2% target was pulled out of thin air.”
But perhaps the most damning comment was made by Harvard professor Benjamin M Friedman (no relation to Milton). In 2018, Friedman wrote, in a book honouring Vítor Constâncio, the former vice-president of the European Central Bank: “There is the arbitrariness surrounding the current 2 percent target. In retrospect, the paucity of serious empirical research underlying the identification of the 2 percent norm, now quite some time back, is a professional embarrassment.”
It’s worth repeating those words – “a professional embarrassment”. One of the most important economic policies in place today, across the world, is based on an impromptu remark and very little, if any, empirical support.
And central banks don’t seem to be listening. There is now considerable discussion out there about raising the inflation target to 3%. For instance, Constâncio himself has recently said that “after overcoming the current wave of inflation, central banks should seriously consider raising their inflation target to 3%”. Nobel prizewinner Paul Krugman and former chief economist at the IMF Olivier Blanchard were officially in favour of this change. As recently as October 2023, this publication reported on such a proposal by the UK’s Resolution Foundation.
Yet this proposal suffers from the same criticism as above: where is the empirical justification? These comments are seemingly just as off the cuff as the original proposal.
We give central banks too much power over our lives and livelihoods, when fiscal policy, which concerns government spending and taxes, is where the battle should be fought. Using interest rates to tackle inflation can lead to serious problems, as anyone with a mortgage knows full well. John Maynard Keynes once said that the use of interest rates “belongs to the species of remedy which cures the disease by killing the patient”. Surely we can think of better ways to do this. The only solution, in my view, is to scrap inflation targeting altogether, and start anew with a deep, systematic examination of what monetary policy is, and what it actually does.
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Louis-Philippe Rochon is professor of economics at Laurentian University, Canada, and editor in chief of the Review of Political Economy
