Why do we have an inflation target of around 2%?

Friday, 7 March 2025

The Reserve Bank has battled to get inflation in the 1-3% range over the past few years - but why is that the target at all?

Inflation was 2.2% in the December 2024 quarter, which was the lowest since March 2021. Inflation in New Zealand has a target of 1-3% with the midpoint being 2%.

Speaking at a Reserve Bank of NZ conference on inflation on Thursday, American economist and former chair of the Federal Reserve, Ben Bernanke, said the 2% midpoint was a “good compromise”.

“It keeps steady-state nominal interest rates a bit higher than a zero target would, giving the central bank more room to cut rates in a recession, while being low enough that households and businesses do not need to think about inflation too much in their economic activities,” he said.

The Reserve Bank of New Zealand was among the inflation targeting pioneers, 35 years ago. Chronically high inflation in the 1970s and 1980s was partly blamed on the policies of a non-independent central bank.

It led to then Minister of Finance Roger Douglas working with officials in 1986 to consider changes to the monetary framework, including operational independence of the central bank with a focus on price stability, which was defined to be between 0 to 2%.

Inflation then dropped from 19% in 1987 to 2% by 1991. It has since been adopted by almost all advanced economies, Bernanke said.

But Bernanke told the NZ gathering on Thursday that inflation targeting was only a framework, and did not prevent policy mistakes or eliminate the possibility of major shocks, like the 2008 global financial crisis, or the Covid-19 pandemic.

“It does not even guarantee low inflation, as the past few years have taught us, although central banks around the world responded strongly to the pandemic inflation shock, and seem on the way to restoring price stability.”

But when compared to the 1970s and 80s, when there were more discretionary and less-focused policies, it has made considerable changes including increasing the predictability of policy, lowered inflation on average, anchored inflation expectations, clarified the goals of the central bank, and increased democratic accountability while strengthening central bank independence, he said.

The Reserve Bank target is set by policy target agreements made between the governor and the finance minister.

The target has changed over the years with the initial objective of 0-2% replaced with a target band of 0-3% in 1996, before in 2002 the target range was narrowed to 1-3% inflation over the medium term. In 2012, an explicit focus was given to the 2% mid-point of the 1-3% target range.

Infometrics chief forecaster Gareth Kiernan said in general, the 1-3% target provided a clear and achievable goal for the central bank.

He said the original 0-2% inflation target was a bit on the low side – although the resulting shifts to 0-3%pa and then 1-3%pa seem to have been more politically driven than anything.

“Over time, people have probably forgotten about how disruptive and negative the effects of inflation can be on households and businesses, so the spike in inflation between 2021 and 2024 has been a good reminder that we shouldn’t ease the target just because we think the Reserve Bank’s monetary policy is overly stringent at times.”