How did 2% become the magic inflation target?

This is an audio transcript of the FT News Briefing podcast episode: ‘How did 2% become the magic inflation target?’

Marc Filippino
Good morning from the Financial Times. Today is Tuesday, January 3rd, and this is your FT News Briefing.

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The UK may face an especially bad recession, and we’ll take a look at what it means for the Netherlands if its economy has reached the limit of how much it can grow. Plus, the Federal Reserve’s New Year’s resolution may sound familiar: bring down inflation to 2 per cent. The FT’s Colby Smith explains where that target came from and whether it’s going to stick around. I’m Marc Filippino and here’s the news you need to start your day.

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Economists think that out of all the G7 countries facing a recession this year, the UK is going to get hit the hardest. The FT surveyed more than 100 UK-based economists. They said not only will Britain have the worst recession, but the country’s recovery will take the longest. Now, there are a few reasons for this. The economists who were surveyed said inflation caused by the war in Ukraine will stick around in the UK longer than other G7 countries. But it’s been made worse by poor policy decisions. Economists point to weak business investment, the government neglecting public services and the damage Brexit has done to trade.

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It’s beginning to look like the Netherlands economy has grown to a point that it’s about to hit a ceiling. The country is getting overdeveloped in a way that’s actually hurting the country. That’s at least what the FT’s Simon Kuper thinks. He’s our Life and Arts columnist and he’s here to explain what he means. Hey, Simon.

Simon Kuper
Hi.

Marc Filippino
OK. So first of all, what does reaching the limits of growth mean in reality for people actually living in the Netherlands?

Simon Kuper
Well, the country has run out of workers. So, for example, a lot of restaurants close at lunchtime. Some trains don’t run because there are no train staff. The country has run out of space very largely, and it’s sort of reached a limit to its nitrogen emissions, which means that a lot of farms have to close because they’re emitting nitrogen through their cows and pigs right next to inhabited areas. And in the Netherlands, pretty much everything happens next to an inhabited area.

Marc Filippino
OK. So I have a sense of why this might be important, but explain to me, why does this matter?

Simon Kuper
Well, it matters because the ways that you could solve the limits of growth are not popular in the Netherlands. So you could import a lot more workers. And, you know, importing workers is not popular in a country with a strong anti-immigration movement. You could get rid of the farms and build houses there. But the Dutch agriculture is the most productive, more or less in the world. So that’s not popular. And you could ask people to work more because the Dutch have the shortest workweek in the developed world, averaging 30 hours. But Dutch people on the whole quite like working shorter hours. You could displace activity to the eastern and northern parts of the country where there’s not many inhabitants, but people want to live around the economic boom zone of the west, and that’s not possible. And anyway, who is going to build these new houses that there are no builders to build them?

Marc Filippino
OK. So I’m gonna push back a little bit, Simon. Is it actually so bad that growth is slowing in the Netherlands? I mean, the whole global economy is slowing down. Why is it bad in this case?

Simon Kuper
Well, it hasn’t slowed down yet. I mean, it’s still booming. And so sort of the last employee has taken. I mean, you raise a big question, which is, is it so bad in a rich country to stop growing? And maybe countries can deal with it. People at the top end, you know, they sort of have enough. And you can, in the Netherlands, you can offer them a short working week and a good work-life balance. And you can say to them, look, you know, your top end incomes have stagnated, let’s say an average of €80,000 a year. And that’s fine. But the problem is also the people at the bottom end who, you know, they want to have higher incomes for themselves and for their children. And you’re saying to them, right, we’re sort of turning the economy to zero here. We’re doing what Japan did. No more growth. And, you know, we’ve seen in recent years that people at the bottom can get politically very angry if they feel that they are being left behind in this way. So without growth, you create political dangers.

Marc Filippino
Simon Kuper is the FT’s Life and Arts columnist. Thanks, Simon.

Simon Kuper
Thank you.

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Marc Filippino
If you’ve listened to Jay Powell give a press conference lately, you know that the chair of the US Federal Reserve is very concerned with bringing down the inflation rate to a very particular number.

Jay Powell
To 2 per cent, down to our 2 per cent, well above our 2 per cent goal.

Marc Filippino
So we hear that 2 per cent target a lot, but where did it come from and why are central banks shooting for it? To help answer some of these questions is the FT’s Colby Smith. Hey, Colby.

Colby Smith
Hi, Marc.

Marc Filippino
So, Colby, can you tell us where this 2 per cent target came from?

Colby Smith
So New Zealand was the first country to set a formal inflation target in 1989. And essentially, you know, what the central bank there and government officials were trying to do was to help to bring down inflation that was running at a level that they considered far too high. And the whole notion of the inflation target was that if a central bank was seen as being independent to adjust interest rates accordingly in order to get inflation down to a certain level and they had a target in mind, it would lead to a situation where price pressures would actually moderate or adjust to whatever that level turned out to be. And when that country saw success, other countries started to adopt similar rules.

Marc Filippino
So, Colby, can you explain why 2 per cent has been so widely adopted? I mean, it’s not just the Fed. The European Central Bank shoots for just under 2 per cent. And a lot of other central banks aim for inflation to be around that number as well. Why is that?

Colby Smith
So 2 per cent came to pass after, you know, a pretty long debate about where was that right sweet spot for the inflation target. Proponents of 2 per cent said that it was seen as a level that was low enough that it didn’t necessarily factor into people’s decisions about how they spend their money, how they invest. It allowed for inflation to hover around a point where it just wasn’t something that they’re thinking about every single day. On the other hand, 2 per cent was seen as an appropriate level because it was high enough to give central banks the capacity to respond in a downturn. The concern was that if inflation was too low, it could lead to a situation where expectations of future inflation also were lower, which in turn could potentially drag down inflation again, which would have the effect of pushing down interest rates. And the problem there is that it would just mean central banks have less room to manoeuvre when there’s an economic contraction. They can only lower interest rates so much unless they were willing to delve into more unconventional policy tools like negative interest rates.

Marc Filippino
Now, someone recently wrote an opinion piece in the FT, Colby, that said central banks should revisit the 2 per cent target. And they also said that advanced economies like the US should shoot for 3 per cent.

Colby Smith
So 3 per cent it definitely feels like the consensus view if you talk to economists who, you know, dare to dabble in this debate at this stage. So the cons, I think, of changing the inflation target right now is the fact that the Fed could lose quite a lot of credibility if they were to say, you know, we’re OK with 3 per cent. People might think, well, what’s stopping them from saying they’re OK with 4 per cent or 5 per cent? And suddenly you have this kind of dangerous situation where inflation expectations get out of hand. People really start to lose confidence in the Fed’s ability and commitment to get inflation down. And then that’s a much worse problem for the Fed to be dealing with. The more obvious positive of a higher inflation target when the time is right to have that debate is that it gives the Fed again more flexibility to respond in economic downturns. Interest rates would be materially higher in that type of environment, and it would just enable the Fed to have a little bit more room to play with in terms of reducing those later down the line.

Marc Filippino
Colby Smith is the FT’s US economics editor. Thanks, Colby.

Colby Smith
Thank you.

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Marc Filippino
You can read more on all of these stories that at FT.com. This has been your daily FT News Briefing. Make sure you check back tomorrow for the latest business news.