Roger Douglas may not be a household name in the realm of monetary policy, but a single throwaway remark had a profound impact on how the economies of the world operate.
On April 1, 1988, during a televised interview about New Zealand’s monetary policy, Douglas, the country’s Finance Minister, made an off-the-cuff remark that he was aiming to reduce inflation to “around 0 to 1%.” (1)
When Don Brash became the governor of the Reserve Bank of New Zealand, he was tasked with formally calculating the inflation target figure based on Douglas’s comments. This resulted in the setting of a target of 0% to 2% to allow more room for manoeuvre. (2) At the time, the idea of a central bank simply announcing its inflation target was considered radical. After all, central bankers had long relied on a certain mystique as one of their tools of power.
While the inflation goal may have reduced that mystique, it created its own kind of magic. By announcing its goals for inflation and granting the central bank independent authority to achieve those goals, New Zealand turned that result into a reality. Businesses and labour unions across New Zealand began assuming that inflation would be around 2%, leading to slower wage and price increases.
As New Zealand successfully curtailed inflation using “Rogernomics,” other countries started to follow suit. The Bank of Canada, Sweden’s Riksbank, the Bank of Japan, and the European Central Bank learnt from New Zealand that high inflation does not lead to continued high economic growth. These countries sought a moderate and stable inflation rate, akin to the Goldilocks theory – not too high, not too low, but just right!
By the mid-1990s, the US Federal Reserve embraced this approach. Although they had internally used a 2% figure for some time, it was decided to declare an explicit target. Initially, a target of 1.5% was proposed, but after the 2008 credit crisis, consensus shifted to 2% to provide more room for economic growth. (3)
It was not until 1997 that the UK implemented a structure in which the government declared the desired inflation rate, leaving the Bank of England to meet that demand. The initial target of 2.5% was revised to 2% in 2003 when Mervyn King became the Bank of England’s governor. To this day, the Bank of England remains devoted to its 2% target, with the governor still required to write a letter to the Chancellor of the Exchequer if inflation deviates by more than one percentage point. (4)
While 2% has become firmly established as a macroeconomic anchor, there is debate about whether it is the right target. King is concerned that bankers have become too fixated on the number and do not give enough credence to other economic indicators such as employment and growth data. The Federal Reserve has already taken steps to adopt a more flexible approach by targeting an average of 2% over a longer time period rather than a fixed target at every point in time. (5)
In recent years, there were calls in the media from the Financial Times and New York Times to consider raising the inflation target to reduce the constraints on central banks, allowing greater flexibility for monetary policy. However, there was no similar clamour to lower the target when inflation was below 2% in five of the seven years between 2014 and 2020. This discrepancy challenges the sensational narrative often favoured by the media, which tends to focus on doom and gloom.
The general consensus among major central banks, as shown in the 2019-2021 strategy review, is to maintain the 2% target. Economic research does not support higher inflation targets. Don Brash shares this sentiment, stating that changing the target from 2% to 4% would create uncertainty about future changes. Disrupting expectations of stability can be as unsettling to markets as any other factor. (6)
Therefore, it seems that the magic number of 2% is now so firmly planted in the soil, that it will take a very large spade to uproot it!
As part of Equilibrium’s service, we use cash flow forecasting to provide a customised outlook for our clients, giving them financial confidence. Since our clients are primarily impacted by inflation in the UK, we prefer to err on the side of caution and use a target of 2.5% instead of the Bank of England’s 2% target.
Tim Latham, a chartered financial planner, further explains our approach, stating that by combining historical data, insights from our investment team, and forward-looking economic data, we create a financial strategy grounded in the real world rather than a theoretical target formulated across various economies.
If you have any questions about the impact of inflation on your hard-earned money, please don’t hesitate to contact us or book a free, no-obligation chat with one of our experts here.
This article is intended as an informative piece and should not be construed as advice.
Sources
(1) bis.org
(2) nytimes.com
(3) nber.org
(6) ecb.europa.eu
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