In 1988, New Zealand’s Finance Minister, Roger Douglas, casually mentioned on television that he’d like to see inflation around 0-1 per cent. The Reserve Bank added one per cent to account for upward biases in inflation measurement, giving us the now-famous two per cent figure. And that was that. No modelling, no votes, yet central bank institutions just followed suit. It became the financial world’s equivalent of the QWERTY keyboard: most did it, it was functional, but arguably a tad suboptimal.
I mentioned last week I would take the contrasting views of the mainstream economists and those who are non-mainstream to balance out the viewpoints.
From the ‘mainstream’ perspective, they might argue the target has worked wonders. Economists like Emi Nakamura and Jón Steinsson argue that a stable, well-communicated two per cent target helps anchor inflation expectations, making prices less volatile and policy more effective. In their view, it’s the foundation which allows central banks to manage the business cycle predictably.
Robert Gordon credits the two per cent target with taming the wild inflation of the 1970s and underpinning decades of economic calm during the so-called ‘Great Moderation’. And Thomas Sargent sees it as a commitment device, a boundary which prevents governments from letting fiscal policy run a little wild and forcing central banks to bail them out by printing money. It’s a line in the sand as they see it.
Claudio Borio at the Bank for International Settlements acknowledges its usefulness but cautions that it ignores financial cycles like asset bubbles and credit booms that develop while consumer inflation stays tame.
Metaphorically, to the mainstream, two per cent is less of a magic number and more a North Star, something solid in an unpredictable sky.
On the other side, a growing chorus of independent and heterodox economists argue this North Star is leading us off course.
Steve Keen (I rate him) is blunt: the two per cent target is “deeply flawed.” It ignores the role of private debt, which he sees as the real driver of economic crises. Inflation might be stable, but if credit is ballooning like it did before 2008, you’re building a house on sand. He points out that Spain’s credit went from +35 per cent of GDP in 2008 to -20 per cent by 2014, triggering a brutal recession, all under the banner of price stability.
Michael Hudson (I also rate) calls the target a smokescreen for preserving the wealth of the financial elite. He argues it protects the value of assets held by the top 10 per cent while stifling wage growth and draining household incomes through rentier mechanisms like housing and healthcare.
Joseph Stiglitz calls it “the wrong tool for modern inflation”, especially when prices are rising due to supply shocks, not excess demand. In this scenario, raising interest rates just kills jobs without cooling the real source of inflation. It’s like trying to fix a broken leg with a slap of Sudocreme.
Stephanie Kelton of the modern monetary theory (MMT) school sees the two per cent target as an arbitrary shackle on government. Why restrain fiscal policy, she asks, when the real limit is the economy’s productive capacity, not some random abstract number? In her view, inflation targeting empowers unelected central bankers to choose unemployment as a policy tool.
Isabella Weber adds that the target is too blunt. Inflation doesn’t happen evenly across the economy. Energy and housing – key “systemic sectors”- often drive overall inflation. Raising rates to tame energy prices is like turning off your fridge to cool the kitchen. Other sectoral tools, she argues, would be far more effective.
Even Robert Gordon, a mainstream economist, concedes that the two per cent target may now require “unacceptably high unemployment” during supply-driven inflation, suggesting a need for more flexibility.
What started as an off-the-cuff comment on New Zealand television has somehow become the 10 Commandments of modern central banking. But scratch beneath the surface, and you’ll find critics from all corners. Their politics may differ, but they share a common worry: that we’ve confused calm seas for safe waters, and tradition for truth.
The two per cent target has, no doubt, given us a sense of order, like a lighthouse guiding ships at night. But if that light is steering us into shallows filled with rising inequality, household debt built on sand, and blunt tools that hit jobs harder than prices, maybe it’s time we asked whether the lighthouse itself is in the wrong place.
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Peter McGahan is the Chief Executive Officer of Independent Financial Adviser Worldwide Financial Planning. Worldwide Financial Planning is authorised and regulated by the Financial Conduct Authority.