Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Set Inflation Targets
Transcript
- Lucas: If I asked you to pick one number that defines modern central banking, I think the winner would be 2 percent. That's the inflation target for most of the world's major central banks. But it wasn't handed down by an economic prophet — it was a practical choice that started in a small country thirty-seven years ago. Luna: New Zealand, right? The Reserve Bank of New Zealand Act of 1989? Lucas: Exactly. They were the first to formally adopt an inflation target. At the time, New Zealand had been through double-digit inflation, and the new law gave the central bank a single objective: price stability. The target they settled on? Initially zero to 2 percent. So the 2 percent ceiling was really the original anchor. Luna: And then it kind of spread like a virus. Canada followed in 1991, the UK in 1992 after they exited the European Exchange Rate Mechanism. Lucas: Right — the UK's exit from the ERM was a disaster for their credibility, so they needed a new anchor, and inflation targeting became that anchor. The Bank of England adopted a target range of 1 to 4 percent. By the mid-1990s, the idea had gone global. The Maastricht Treaty, signed in 1992, embedded price stability into the European Central Bank's mandate before the ECB even existed. Luna: So why 2 percent? Why not zero, or 5? Lucas: Good question. Zero inflation sounds clean, but economists worry about a few things. One, official inflation measures tend to overstate true inflation — quality improvements get missed. Two, zero gives you no buffer against deflation. If you target zero and accidentally overshoot into negative territory, you're in a deflationary trap. Three, labor markets are stickier on the downside — it's easier to cut real wages by letting inflation run at 2 percent than by forcing nominal wage cuts. Luna: So 2 percent is basically a compromise between the costs of inflation and the risks of deflation. But is it still the right number today? Lucas: That's the debate. After the 2008 financial crisis, many central banks found that 2 percent wasn't enough room to cut rates during recessions because rates were already near zero. So they started experimenting with average inflation targeting, or AIT. The Federal Reserve announced that shift in August 2020 — they now aim for inflation that averages 2 percent over time, meaning they let it run above 2 percent after periods below. Luna: But then we had the post-pandemic inflation spike, and suddenly the problem was too much inflation, not too little. That really tested the framework. Lucas: It did. The Fed's AIT framework was introduced in a low-inflation world, and then inflation hit 9 percent in mid-2022. Some critics said the Fed was too slow to raise rates because they were still trying to 'make up' for past undershoots. Meanwhile, the ECB and the Bank of England, which don't have AIT, were also late — so maybe it wasn't the framework, it was the shock. Luna: Let's step back. How do central banks actually operationalize this target? I mean, they don't have a dial they can turn. Lucas: They use the policy rate as their primary tool. The idea is that by raising or lowering the short-term interest rate, they influence borrowing costs throughout the economy, which then affects spending and, eventually, prices. But there's a lag — usually 12 to 18 months — so they have to be forward-looking. That's where the Taylor Rule comes in. Luna: John Taylor's formula from 1993. It says the policy rate should equal the neutral rate plus 1.5 times the inflation gap plus 0.5 times the output gap. Lucas: Exactly. It's not a law, but it's a useful benchmark. The Taylor Rule suggests that if inflation is 1 percent above target, the central bank should raise rates by 1.5 points above the neutral rate. That gives a systematic response. Most central banks don't follow it mechanically, but it's a reference point for evaluating their decisions. Luna: And the neutral rate itself — R-star — is also a moving target. So the whole framework is built on estimates of unobservable variables. Lucas: Right, and that's the challenge. Since the pandemic, estimates of R-star have been creeping up. The New York Fed's measure, the Laubach-Williams model, puts it around 1.2 percent in real terms as of early 2026. If R-star is higher, then policy rates that seemed restrictive might actually be neutral. That complicates the inflation targeting conversation. Luna: We should also talk about the Bank of Japan. They've been fighting deflation for decades, and in 2013 they adopted a 2 percent inflation target. It hasn't worked. Lucas: It hasn't — or at least it took much longer than expected. The BOJ's experience shows that inflation targeting isn't magic. You can set a target, but if the economy is in a liquidity trap, if expectations are anchored too low, it's very hard to generate inflation. Governor Kuroda's massive asset purchases, yield curve control — they all aimed at hitting 2 percent, and they only got there briefly in 2022-2023 before falling back. Luna: So what's the alternative? Some economists argue for nominal GDP targeting instead. That would target the growth rate of total spending, not just prices. Lucas: Nominal GDP targeting has its fans, including Scott Sumner and the Market Monetarist school. The idea is that if you target nominal GDP growth — say 4 to 5 percent — you automatically accommodate supply shocks. If a bad harvest pushes up prices, you don't need to tighten policy because real output falls, and nominal GDP stays on track. But central banks have shown little interest in switching. The communication challenge would be huge. Luna: Plus, the public barely understands inflation targeting as it is. Imagine explaining nominal GDP targets on the evening news. Lucas: That's exactly the issue. A key part of inflation targeting is anchoring expectations. If people believe the central bank will keep inflation at 2 percent, then wage negotiations and price-setting behavior adjust accordingly. That self-fulfilling element is powerful. Switching frameworks risks unanchoring those expectations. Luna: So is the 2 percent target here to stay? Lucas: If walking through the economy with us has made something click, you know these shows are built to give you one concrete takeaway per episode — no fluff, no ads. The reason we can keep doing that is listener support. If today was actually useful to you, the way these stay ad-free is at buy me a coffee dot com slash fexingo. It's a simple way to keep this kind of conversation going. Luna: Yeah, it really does make a difference. Every contribution helps us keep the episodes focused and independent. Lucas: So back to the target. I think 2 percent will remain the default for the foreseeable future, but we'll see more flexibility in how it's interpreted. The Fed's AIT framework, the ECB's symmetrical target — those are signs that central banks want to avoid the zero lower bound trap without abandoning the number. The real action will be in the communication strategy, not the number itself. Luna: And in the tools. We've seen quantitative easing, forward guidance, yield curve control — all ways to influence longer-term rates when the policy rate is stuck at zero. Lucas: Right. The inflation target gives them an objective, but the toolkit has expanded massively. One interesting development is the use of tiered reserve systems, like the ECB's two-tier system for excess reserves. That's a way to implement negative rates without punishing banks too harshly. It's all in service of hitting that 2 percent target. Luna: So to wrap up: inflation targeting started in New Zealand as a pragmatic response to high inflation, was codified globally through the Maastricht Treaty and the UK's ERM exit, and has evolved from a rigid rule to a flexible framework. The 2 percent number is a convention, not a law of nature, but it's deeply embedded. Lucas: Exactly. And the big question for the next decade is whether central banks can maintain that target in a world where supply shocks seem more frequent — pandemics, wars, energy transitions. The Phillips curve has flattened, but inflation expectations remain anchored. If that changes, we might see the first serious reconsideration of the 2 percent norm since the 1990s. Luna: So keep an eye on the Bank of Japan's review. They're doing one in 2026, and if they move away from 2 percent, others might follow. Lucas: That's the canary in the coal mine. Alright, that's all for this episode of Monetary Policy Explained with Fexingo. I'm Lucas. Luna: And I'm Luna. Catch you next time.