The Magic Number: Why Central Banks Aim for 2% Inflation—and How It Impacts Your Investments

Why 2% Inflation Target?

The 2% inflation target is a widely used benchmark among central banks like the Federal Reserve, the European Central Bank (ECB), and others. It’s aimed at creating a stable economic environment—high enough to encourage spending and investment, yet low enough to prevent the erosion of purchasing power or excessive volatility in prices. But why is 2% chosen? It may seem like a random number selected by the central bankers. Why don't central banks aim for 0% inflation, implying a zero percent price stability target? Anything above that would be inflation, and anything below would be deflation. Central banks' lives would be simpler. However, the reality is more complex than it appears. 

The concept of a specific inflation target was pioneered by New Zealand in 1989. The Reserve Bank of New Zealand (RBNZ) was the first to adopt an explicit inflation target, initially aiming for a range of 0-2% before later adjusting it to around 2%. This idea gained popularity because it provided a clear and measurable goal for central banks, enhancing transparency and accountability. Economic studies recommend targeting a slightly positive inflation rate for three reasons:

The measured inflation rate is believed to overstate the true inflation rate. Inflation is measured by tracking a basket of the various goods and services via indices like the consumer price index (CPI). The overstatement of the measured inflation rate can occur due to issues like unaccounted quality improvements, where prices rise but products also get better, and substitution bias, where consumers shift to cheaper alternatives as prices change. These factors mean that the inflation rate as measured by indices like the CPI may appear higher than the actual cost-of-living increase. A slightly positive target helps central banks accommodate these measurement biases without risking deflation.

The second reason for the target inflation rate being a positive number invloves human psychology and what economists call "wage rigidity". When inflation is low but positive, it allows for gradual real wage adjustments without the need to reduce nominal wages, which people generally resist. A small amount of inflation acts as a buffer, subtly lowering real wages when needed. This helps employers manage costs without reducing morale and productivity through wage cuts.

The third reason is what economists call the "zero lower bound (ZLB)" on interest rates. The principal tool that central banks use when they need to stimulate the economy and try to prevent the inflation rate from setteling below its target is the overnight interest rate. When the economy needs a boost, central banks lower interest rates, making borrowing cheaper to encourage spending and investment. However, they can’t lower rates below zero without risking adverse effects on banks and lending practices. A positive inflation target, like 2%, allows for a buffer above the ZLB, giving central banks room to cut rates effectively when needed to stimulate economic activity and avoid deflationary pressures.

While one might argue for higher inflation targets to provide greater flexibility in monetary policy, this approach comes with trade-offs. A higher target could erode confidence in the central bank’s commitment to preserving the purchasing power of money. It risks diminishing public trust and political support, as people may perceive the central bank as less focused on controlling inflation. Striking a balance between flexibility and credibility is essential for maintaining long-term economic stability and trust in the currency.

How It Impacts Your Investments

When central banks maintain a steady low inflation target in the economic, investors feel more secure. For example, in a 2% inflation environment, a stock investor can plan for stable growth, as companies can adjust to moderate price increases without major profit disruptions, leading to more stable stock prices and more investment opportunities.  

A steady 2% inflation rate also benefits low-income people by providing predictable price increases, allowing them to plan their spending and savings better. For instance, with stable inflation, food and housing costs don’t suddenly spike, making it easier to manage tight budgets. Additionally, this low and consistent inflation helps wages rise gradually, which can improve purchasing power without the risk of prices outpacing earnings, providing a more stable standard of living for those on fixed or limited incomes.

Disclaimer

This article is for informational purposes only and should not be considered financial advice. Markets are complex and unpredictable, and various factors beyond valuation metrics can influence future performance. Always conduct your own research or consult with a financial advisor before making investment decisions. Past performance does not guarantee future results.