A few relatively young central bank and Treasury experts in New Zealand were struggling to control double-digit inflation in an economy that was less than 1% the size of the U.S. counterpart more than 30 years ago.
What if they simply informed everyone the ratio should be substantially lower—say, about 2%—and then set their sights on that? they pondered.
Roger Douglas, the Labour Party’s finance minister at the time who developed the strategy in collaboration with the Treasury & Reserve Bank of New Zealand (RBNZ), said it came as a bit of a shock to everyone. When it was revealed that it would be 2%, it kind of stuck.
Inflation targeting was therefore established.
Since its introduction in 1990, the 2% inflation goal phenomenon has spread from Wellington throughout the globe to establish itself as the accepted standard among central banks of all sizes for establishing the target inflation rate in the minds of the public.
But given that inflation is expected to persistently remain over 2% for some time, the price surges brought on by the COVID-19 outbreak are likely to put their commitment to it to the test in the months to come.
The inventors of inflation targeting in New Zealand stand by it even as some observers debate whether that level is still appropriate today, in most cases debating whether it should be raised to mitigate the harm that high-interest rates used by central banks to achieve it are doing to growth and employment.
In reality, Arthur Grimes, the former head economist and senior RBNZ official who was regarded as one of the policy’s main architects, would prefer that the objective include a lower range.
The obvious place to start is zero, which essentially states that prices should, on average, be similar to current prices after 10 years. How could anyone desire something different? said he.
When inflation targeting was originally made mandatory, the upper limitation was set at 2% and the lower limit at 0%. At the time, inflation averaged 7.6%, but it had consistently tracked above 10% between 1970 and 1990, and few individuals believed the aim to be attainable.
Former RBNZ economist Michael Reddell, who at the time oversaw the monetary policy area of the department of economics, said that there were some very scathing internal arguments and that not everyone was especially persuaded that it was appropriate to aim for something that low.
It wasn’t the world’s most sophisticated scientific procedure. Resources were scarce. He added that no one has ever done this before.
significant monetary tightening followed the introduction of the inflation objective, with 90-day rates reaching 15% in 1990.
After a year, inflation had dropped to 2%, and New Zealanders’ expectations for inflation had quickly changed to reflect the new reality.
However, there were significant short-term consequences for firms and employees as a result of the economy’s stagnation between 1989 – 1994 and the increase in the rate of unemployment to double-digit levels.
The aim has changed twice since then, first to a range of 0% to 3% and then, in 2002, to a range of 1% to 3%.
Politics played a big role in the choice and the ensuing policy.
In order to win over voters, governments have gone on spending binges.
The central bank and Treasury were tasked by Douglas, the ex-finance minister, to develop a strategy to stop this from happening again.
It was initially debatable whether to target the money supply or interest rates, but it was ultimately agreed that it would be preferable to target the end result: inflation.
