The 2% inflation target is a common policy objective pursued by some central banks around the world, especially the U.S. Federal Reserve, the European Central Bank, and the Bank of Canada. This target is based on the belief that moderate and stable inflation can have potential ongoing benefits for an economy. With that said, it is important to note that the empirical evidence supporting the specific 2% target as a universally optimal level is a subject of ongoing debate among economists. So, while not universally accepted, there are some arguments and empirical findings that can be considered in favor of a 2% inflation target:

Price Stability and Avoiding Deflation: One of the primary reasons for targeting positive inflation is to avoid the risk of deflation, which is a sustained decrease in the general price level. Deflation can lead to reduced consumer spending and business investment as individuals and firms delay purchases in anticipation of lower prices in the future. This can contribute to economic stagnation. A modest positive inflation rate, such as 2%, helps prevent this scenario. Deflation could also mean that the economy overall is in a recession. Deflation may indicate losses in jobs, reduction in costs and overheads to lower prices of goods and services.

Nominal Interest Rates: A 2% inflation target provides central banks with more room to maneuver in terms of monetary policy. When inflation is low, nominal interest rates (the rates reported by central banks) are also low. This limits the central bank's ability to use conventional interest rate cuts to stimulate the economy during periods of economic downturn. A slightly higher inflation rate allows central banks to adjust interest rates more effectively. We have seen some swings in both rates and inflation levels that counter this argument over the past two years. This clearly indicates that there is more to inflation than just employment levels and investments. Constraints on supply chains and misaligned employment levels in specific industries like logistics can also create supply/demand imbalances that are not easily repaired with a one-trick pony like interest rates.

Wage Adjustments: Moderate inflation can help facilitate adjustments in real wages over time. When there is inflation, nominal wages can increase without necessitating actual wage increases, which might lead to resistance from workers. This flexibility can help in maintaining labour market stability and avoiding unnecessary conflicts. Within Canada and the United States, full-time workers have this understood annual raise or pay increase that is generally going to be in line with that 2% target. This usually has the ripple effect of raising wages by 2% meaning that corporate operational costs rise by 2% and thus products and services pricing will likely also rise by around 2%. Imbalances in that ripple will also create inflation anomalies that are likely not influenced by interest rate changes.

Price Signals: Inflation can serve as a price signal, indicating relative changes in the demand and supply of goods and services. A consistent and moderate level of inflation allows prices to adjust over time, helping markets to function more efficiently. Maintaining this level of balance means that you should have the predictable outcome of wages rising, costs rising and goods and services rising in a predictable manner that if maintained means that everything slowly gets more expensive, but nobody should really see a difference because their wages are in lock step. When supply/demand imbalances persist, then basic cost of living items start to rise faster than the 2%, and that is when the illusion bursts and workers struggle to understand why they can’t cover their expenses over the course of a month.

Debt Dynamics: Moderate inflation can also have positive and negative effects over the real value of debt over time. This could be beneficial for both governments and private borrowers, as it makes it easier to manage and service debt obligations. Moderate inflation levels can create a form of mild debt erosion. Inflation will erode the real value of debt over time. When the general price level rises, the purchasing power of your currency decreases. As a result, the nominal value of debt remains fixed, but its real value (adjusted for inflation) decreases. This effectively means that borrowers will need to repay their debt with currency that has lower purchasing power. Obviously, there are also downsides to debt dynamics with inflation. When interest rates move rapidly to change inflationary imbalances, the cost of borrowing on existing debt may also move with those rate changes like on some loans and certain types of mortgages. This may make it harder for some borrowers to meet their debt obligations as the interest being paid may outstrip increases in their income. This will also have a greater impact on fixed incomes and create uncertainties that will impact financial markets within a country and globally.

Anchoring Expectations: A well-communicated and consistent inflation target can help anchor inflation expectations among households, businesses, and financial markets. When economic agents have confidence in the central bank's commitment to price stability, it can help stabilize inflationary pressures and contribute to macroeconomic stability. The key here is ‘stability’ when everything is firing properly and the targets and ripple effects are maintained, then the expectations of workers, companies, governments, and markets are nominal. But, when imbalances persist for extended periods of time, interest rates move at an accelerated pace and costs continue to rise above the target, then this is a recipe for pending economic collapse as all of the debt and borrowing costs become unsustainable with out wild increases in prices of goods and services above the expected 2% levels.

This challenge with a single digit inflation target for an entire economy is that it grossly oversimplifies the dynamics of supply and demand and must continually find balances for markets and commodities that stubbornly don’t follow 2% rules and basic ripple effects. Significant changes in the price of oil can impact the costs of manufacturing, shipping, and transportation across every sector. Sudden plunges in commodity markets can put a resource-based economy very quickly into negative inflation. This is why central banks create dozens of different views on the economic indicators that contribute to inflation in order to determine if a relevant subset of indicators is hitting their target.

Ultimately, the choice of an inflation target involves a trade-off between different economic objectives, and central banks carefully consider a range of economic indicators, models, and empirical studies when setting their inflation targets. It should still be clear that while a 2% rate is sometimes achievable it is not practically sustainable for any length of time.

Why the 2% Inflation Target?