Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Use Inflation Targeting to Anchor Expectations
Transcript
- Lucas: Central banks today almost universally target inflation at around 2 percent. But that number wasn't handed down on stone tablets. It's a relatively recent invention. Luna: Right. I remember reading that the first explicit inflation target came from the Reserve Bank of New Zealand in 1990. Is that right? Lucas: Exactly. New Zealand was the pioneer. In 1990, the Reserve Bank Act set a goal of maintaining price stability, and the bank adopted a target range of 0 to 2 percent inflation. That was the first time a central bank announced a specific numerical target. Luna: Why 0 to 2? And why did it eventually settle at 2 percent for most central banks? Lucas: Good questions. The 0 to 2 range was somewhat experimental. But over time, central banks learned that a little inflation is actually helpful. Zero inflation risks deflation, which can be disastrous. And a positive target gives a buffer against measurement errors in inflation statistics. By the 1990s, many central banks adopted 2 percent as the sweet spot. Luna: So it's not a magic number. It's more like a convention that worked. Lucas: Precisely. The Bank of England followed in 1992, then the Bank of Canada, the Riksbank, and eventually the European Central Bank, which targets inflation below but close to 2 percent. The Fed formally adopted a 2 percent target in 2012, though it had acted as if that was the target for years. Luna: The Fed's a latecomer then. But I recall they later switched to 'flexible average inflation targeting' — FAIT — in 2020. What was that about? Lucas: FAIT was introduced in August 2020. The idea was to allow inflation to run above 2 percent for some time after periods when it ran below, aiming for an average of 2 percent over the cycle. This was partly a response to the post-2008 era of persistently low inflation. Luna: And did it work? Because we saw inflation spike way above 2 percent in 2021 and 2022. Lucas: That's the irony. FAIT was designed to prevent inflation from being stuck too low, but almost immediately after its introduction, inflation surged. The Fed then had to tighten aggressively, raising rates at the fastest pace in decades. FAIT effectively became moot. Luna: So the framework didn't cause the inflation, but it didn't help contain expectations either. Lucas: Right. The framework was for a different environment. But the key point is that inflation targeting is as much about communication as about the number itself. By announcing a target, a central bank shapes what businesses and workers expect future inflation to be. Luna: That's the famous 'anchoring of expectations.' If people believe the central bank will hit 2 percent, they set wages and prices accordingly, and that helps deliver the target. Lucas: Exactly. It's a self-fulfilling prophecy in a good way. But if the central bank loses credibility, expectations become unanchored. Then inflation can spiral. That's why the ECB and the Fed talk constantly about their commitment to 2 percent. Luna: But not all central banks target 2 percent. The Reserve Bank of New Zealand now targets 1 to 3 percent. The Bank of Japan has long struggled to achieve its 2 percent target, battling deflation for decades. Lucas: Japan is the cautionary tale. The BoJ adopted a 2 percent target in 2013 under Governor Kuroda, but inflation stayed near zero for years. It only recently rose above 2 percent, but the BoJ has been cautious about tightening. That shows how hard it is to raise inflation once deflationary expectations set in. Luna: So the target is only as good as the credibility behind it. And credibility is built over years of consistent action. Lucas: Yes. And there's a debate now about whether 2 percent is still the right number. Some economists argue that in a world of structurally lower neutral interest rates, a higher target — say 3 or 4 percent — would give central banks more room to cut rates in recessions. Luna: But wouldn't that erode purchasing power faster? And wouldn't it be hard to get people to accept 4 percent inflation after decades of 2 percent? Lucas: Both are valid points. Changing the target would be a massive communication challenge. And high inflation is deeply unpopular, as we saw in 2022. So most central banks are sticking with 2 percent, at least for now. Luna: So what's the takeaway for someone who doesn't follow central banking closely? What should they understand about inflation targeting? Lucas: The takeaway is that the 2 percent target is a convention — but a powerful one. It gives a clear yardstick for policy, anchors expectations, and helps avoid both deflation and runaway inflation. It's not perfect, but it's the best system we've found. Luna: And it all started with a small island nation taking a gamble in 1990. Lucas: Exactly. So next time you hear a central banker say '2 percent,' remember it's a story of credibility, learning, and a little bit of luck.