Why Central Banks Target 2% Inflation

What is discussed, and when

1. 0:00 – 3:00: Brilliant, US Federal Reserve
2. 6:00 – 9:00: Milton Friedman
3. 9:00 – 12:00: National Bureau of Economic Research
4. 12:00 – 15:00: Brilliant, Alan Blinder, Bank of International Settlements

Notable quotes from "Why Central Banks Target 2% Inflation"

• This video is sponsored by Brilliant. Go to brilliant.org/theplainbagel.

  about Brilliant · at 0:00

• In fact, the first country to implement an inflation target, New Zealand, only did so 36 years ago. And the US Federal Reserve, didn't have an explicit inflation target until 1996.

  about US Federal Reserve · at 1:27

• Well, there is certainly that consideration. And Milton Friedman, a famous economist, once called inflation taxes without legislation, which is a pretty fair assessment. Inflation is fueled by government spending at the.

  about Milton Friedman · at 7:14

• Again, possibly coming from technological innovations. One research paper by the National Bureau of Economic Research, for example, highlights that during the late 1800s, the…

  about National Bureau of Economic Research · at 9:46

• Something highlighted by former Fed chair Alan Blinder, who has highlighted that some academics argue we should increase the inflation rate with him arguing that if we could go back in time, a somewhat bigger inflation target.

  about Alan Blinder · at 12:20

Who and what is mentioned in this episode?

People

• Milton Friedman — Person · 1 mention · first at 7:15
• Alan Blinder — Person · 1 mention · first at 12:22

Companies & orgs

• US Federal Reserve — Company · 1 mention · first at 1:31
• National Bureau of Economic Research — Company · 1 mention · first at 9:50
• Bank of International Settlements — Company · 1 mention · first at 13:07
  Not to say inflation targeting methods haven't changed over time. For example a paper by the Bank of International Settlements found that while many central banks for developed…

Sponsors

• Brilliant — Sponsor · 3 mentions · first at 0:00

Full transcript with timestamps

0:00 This video is sponsored by Brilliant. Go to brilliant.org/theplainbagel. Scan the QR code on screen or click the link in the description to start learning for free today and for 20% off an annual premium subscription. Hey everyone, it's Richard. You're watching the plain bagel. The idea of countries targeting a given inflation rate is something that most of us take for granted when discussing central bank policies. After all, many countries including here in Canada and the United States, task their central banks with maintaining price stability. So it makes sense that they establish some sort of public goal for guiding their monetary policy and tracking their progress. And today we have roughly 45 individual countries and the entire Euro area establishing some sort of public inflation target with many including all of the G7 nations, the Euro zone, and even just recently China opting for a 2%

0:49 target, meaning that every year they look to have their price levels increase by 2%. But why? After all, it's obvious that a 2% inflation rate would be better than say 100%. It might still sound a bit arbitrary or even backwards. If the central bank's objective is to maintain price stability why not target 0% inflation? Or heck why not try to lower prices so that households can actually afford more goods over time with their savings put aside? Well, the truth is that the origin of this 2% target is in fact pretty arbitrary and probably a lot more recent than you might otherwise expect.

1:27 In fact, the first country to implement an inflation target, New Zealand, only did so 36 years ago. And the US Federal Reserve, didn't have an explicit inflation target until 1996. And even then, the target was only made public starting in 2012. And yet despite all this, it's quickly become part of central bank dogma with Japan up until recently even pushing to get its inflation rate up to 2% after years of stagnant and falling prices. So, what's so special about this 2% rate? Well today we'll talk about the bizarre origin of this figure, why it's been maintained, and the justifications for targeting any inflation at all, the arguments against such a target, and how these policies ultimately impact the economy as a whole. But to start things off, let's start again with that origin of this figure back in New Zealand. You see, in 1989, as the world was still grappling with fairly high inflation

2:17 rates, we saw the country who itself was dealing with years of double-digit inflation pass a bill that sought to make its central bank independent from the government to allow to freely pursue monetary policy. And while not the focus of the legislation, the bill also instructed the finance minister and the head of the central bank to establish an inflation target with the country ultimately settling on a target range of 0 to 2% inflation every year. And as for how we arrived to this figure that would forever shape monetary policy moving forward, well, seemingly a TV interview.

2:47 You see, a year earlier, the previous finance minister, Roger Douglas, in an interview highlighted that he would like to target inflation of between zero and 1% uh before this legislation had been passed. And allegedly, the country just kind of went with that with the central bank and the finance minister increasing the upper bound to 2% to allow for a bit more flexibility. That's it. This monumentally important figure was effectively pulled out of thin air. So, yeah, not much of a robust or empirical process for getting to this figure. But what's interesting about this policy is that it seemingly worked.

3:21 Inflation dropped from its double-digit range in the late 1980s to within its target range after just a few years with economists finding that by communicating an inflation rate to the economy, it actually helped central banks achieve this objective by influencing expected inflation. You see, if a central bank is viewed as credible and independent by market participants, then communicating an inflation target helps to anchor inflation expectations, which influences the behavior of those market participants. Banks will assume a 2% interest rate when they make their loans. Unions will bargain for a 2% annual increase to ensure that salaries keep up with that expected inflation rate. And these actions in and of themselves lead inflation to becoming that 2%. So despite the experimental nature of this regime, it quickly gained traction among many developed nations.

4:08 And despite there being not much of an empirical process behind it, there were still some key arguments supporting the idea of targeting a low positive inflation rate that are still used to the state to justify the figure. Firstly, 2% is viewed as being low enough as to not materially impact the purchasing power of the dollar from year to year. Yes, of course, any money that you stow under your mattress for the long term is going to see its purchasing power fall quite a bit over your lifetime. Even at a 2% inflation rate, a dollar today loses half of its value over 35 years. But in the short term it's viewed as having a minimal impact on the dollar store value. Secondly having an inflation target above 0% gives central banks more room to carry out monetary policy. Uh you see inflation rates have a direct impact on interest rates charged in an economy. uh because naturally if the money you lend

4:55 out to people is losing value over time you're going to want to be compensated for that lost value when that amount when that loan is eventually paid back to you. So lenders will directly increase the interest rates they charge based on expected inflation rates. So the higher the central bank's targeted inflation rate, the higher interest rates in the economy should be. And having higher interest rates give central banks more room to cut set interest rates to stimulate the economy given that 0% sort of stands as a lower bound. Yes, we've seen examples of negative interest rates, but for the most part, 0% is the least you can charge on lent money. So, by targeting a higher inflation rate, central banks can have a larger impact on the economy if they expect a recession or severe contraction. And another aspect as well with all of this is that a positive inflation rate makes it easier for companies to reduce real wages of their

5:43 employees in response to economic shocks. Now, I know what you're thinking. Richard, what the hell? Why are we making it easier for companies to cut our incomes? That uh sounds like a conspiracy to screw over workers. And we'll get into the shortcomings of this philosophy in a moment. But the point is that when an economy sees demand fall during a recession, for economies to stabilize themselves, companies theoretically should be able to reduce wages, lay off employees, and ultimately lower their prices to allow the economy to return to its full GDP potential. The problem is that in practice, wage cuts are actually pretty rare with companies instead opting to just laying off employees when they need to reduce their labor costs. But with a positive inflation rate, companies can keep wages stagnant, thereby effectively cutting the wages in real terms and allowing economic activity to normalize and reach

6:30 that point of equilibrium with the same principle applying to interest rates which can dip into negative territory in real terms when there's positive inflation. And finally, the last justification for why central banks target a 2% inflation rate is that it's viewed as being high enough to avoid deflation or price levels decreasing over time. Uh since inflation often deviates from the central bank's target in any given year, the higher the target, the less likely it is for price levels to dip into deflation territory.

6:57 Now, that does bring us to a question that many find quite frustrating. Why do economists treat deflation like the boogeyman? After all, it sounds like a good deal. Who wouldn't want prices to fall every year to reward them for putting money aside? All this just kind of sounds like an excuse for the government to inflate their currency. Well, there is certainly that consideration. And Milton Friedman, a famous economist, once called inflation taxes without legislation, which is a pretty fair assessment. Inflation is fueled by government spending at the expense of household wealth. But the general concern is that while yes deflation could be beneficial for the households that have meaningful savings put aside, it does come with a number of other consequences. uh the main one being that deflation is thought to reduce economic activity by just doing that incentivizing individuals to save their money rather than spending it.

7:46 After all, if the car or dishwasher that you want to buy is going to be cheaper a year from now or even 2 or 3 years down the line, then it's going to incentivize people to put off that purchase until it's absolutely needed. Compared to inflation, which incentivizes people to spend their money now and boost economic activity, economists also fears something called deflationary spiral. As prices fall, companies are faced with lower profits, which leads them to cut costs by cutting jobs and lowering wages, which leads to less spending and investing in the economy, which brings us back to more deflation and continues the vicious cycle. Something that can ultimately end in a severe economic contraction that can prove difficult to pull out of with monetary policy given again the lower bound on interest rates.

8:25 something we've seen in countries like Japan, which experienced the so-called lost decade in the 1990s, where crash in its stock and real estate market was followed by a decade of sluggish performance and low inflation or even deflation. And when we're sort of assessing the pros and cons to the economy as a whole rather than individuals, you might have caught one of the important implications for households is that falling real income as well as rising unemployment. So yes savings might become more valuable, but it might get harder to accumulate any money in the first place. So, while deflation can be great for those who already have money, it can make it harder to accumulate and can even increase the real burden of outstanding debts. Because things like mortgage and credit card balances have a fixed dollar amount that you owe at the end of the term, that amount is going to become more and more valuable in real terms

9:11 making it harder and harder to pay off especially if you face falling income which is important when you consider how indebted many countries and their households are in the current economic environment. Now, of course, there's the argument that inflation has incentivized this debt accumulation over time. And it's worth highlighting that not all deflation is necessarily bad. Technological innovation, for example frequently leads to productivity gains and falling prices. And while deflation can be a sign or trigger of falling demand, we have seen periods of strong economic growth coupled with falling price levels due to increases in supply.

9:46 Again, possibly coming from technological innovations. One research paper by the National Bureau of Economic Research, for example, highlights that during the late 1800s, the global economy saw both falling prices and rapid economic expansion in the face of the industrial revolution. With the paper arguing that while the constrained money supply from the gold standard negatively impacted economic activity this was more than offset by the positive impact of those technological advancements., And, one, of the, biggest issues people have with positive inflation targeting is that while theoretically it shouldn't really matter what this target is, given that you should see incomes increase at the same pace as inflation and savings rates at bank accounts compensate for this lost spending power. In practice, inflation does not apply to all these areas evenly. And you can see wages, for example, fall behind despite price

10:35 levels continuing to increase. Even measuring inflation and tracking the progress of this 2% target has proven a contentious thing. While central banks often use the consumer price index or some variant like the core consumer price index to assess how closely they are to their target, these indices don't always capture the actual price increases that households are experiencing given that they don't account for things like substitution where households change their spending behavior based on changing prices. So it's worth noting that not everyone agrees with a 2% target. And there are known costs to inflation. Beyond the deterioration of savings, inflation also comes with menu costs, meaning the costs associated with companies having to frequently change the price of their goods. And inflation tends to impose a higher tax burden on households given that tax brackets aren't often indexed

11:20 to inflation. So, a higher nominal household income leads to a higher percentage tax rate even if real wages aren't increasing. However, the problem is that it's difficult to prove empirically which targeting regime whether it be moderate inflation or even deflation, would be optimal for economic activity given that most persistently deflationary economies existed before the Second World War when data collection wasn't to the same degree or quality. In fact, one of the biggest criticisms of schools of economic thought that advocate for deflation is that they don't have much empirical evidence to support their arguments.

11:52 It's also difficult, of course, to isolate the influence of inflation or deflation on the economy outside of extreme examples in whether these exist as symptoms or causes of economic activity. What is more broadly accepted however, is that it's the unexpected inflation and deflation that tends to be detrimental to economic activity uh given that they tend to be more disruptive to the equilibrium of the market. And interestingly, there are some economists who have advocated for even higher inflation targeting. Something highlighted by former Fed chair Alan Blinder, who has highlighted that some academics argue we should increase the inflation rate with him arguing that if we could go back in time, a somewhat bigger inflation target quote would have been a better choice.

12:33 However, one issue highlighted by the economist and one reason we still have 2% inflation targeting despite the arbitrary origin of it is that the fact that this rate has already been set makes it very difficult to now change. Because a key component of inflation targeting working is the credibility of central banks. Something that changing a long-term inflation rate could have a negative impact on. So in a way, part of the reason we have a 2% inflation target from, many, of these, developed, nations, is inertia and the fact that now it's a little difficult to change. Now that's not to say inflation targeting methods haven't changed over time. For example a paper by the Bank of International Settlements found that while many central banks for developed nations have tightened their numerical inflation targeting over time, uh moving from targeting within a range to an explicit figure, the time horizon for achieving

13:20 this objective and the focus on other factors like employment has increased over time. And there may come a day where we see a meaningful shift in inflation targeting. But as of today those are the arguments for why we have 2% inflation targeting. And it wasn't a very empirical process to get to this magical figure, but still some meaningful arguments supporting and justifying that targeting regime. But if you like the math side of these arguments and learning how statistics can be used to better inform these types of decisions or other scientific topics uh you should definitely check out today's sponsor, Brilliant. Because as much as I love talking my audience's ear off about these different topics, it's been demonstrated time and time again that one of the most effective ways to learn a given topic is through something called active participation. I.e.

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14:43 a few minutes a day or you just want to lean in, hustle in, and put some hours into one of the platforms many topics. And the best part is that you can try Brilliant completely free by heading to brilliant.org/theplainbagel, org/theplainbagel, scanning the QR code on screen, or clicking the link in the description which also give viewers 20% off an annual premium subscription, which gives you unlimited daily access to everything on the Brilliant platform. So, thank you, Brilliant, and thank you guys for joining me today. I hope you found this video helpful. If you did, please do make sure to like, subscribe, all that good stuff. It does help the channel tremendously. And let me know your thoughts on inflation targeting. Again it's going to be a contentious topic to go over, but whether you think 2% makes sense or you're someone who advocates for deflation, happy to hear the discussion down in the comments. Thanks

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Questions about this episode

What is discussed in "Why Central Banks Target 2% Inflation"?

In order: 0:00 Brilliant, US Federal Reserve; 6:00 Milton Friedman; 9:00 National Bureau of Economic Research; 12:00 Brilliant, Alan Blinder, Bank of International Settlements.

What is mentioned in this The Plain Bagel episode?

6 people, works and ideas are mentioned, including US Federal Reserve, Milton Friedman, National Bureau of Economic Research, Alan Blinder, Bank of International Settlements. Each one on this page links to its own page with every episode that mentions it.

How long is "Why Central Banks Target 2% Inflation"?

The episode runs 15 min; the transcript is about 3,010 words in 23 timestamped sections.

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