Are central bankers fundamentally misguided? | Business| Economy and finance news from a German perspective | DW | 27.09.2019
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Are central bankers fundamentally misguided?

There's no denying that central bankers are fixated on achieving an inflation rate of 2%. Persistently they fail. So why the obsession with this arbitrary metric, asks DW's Kate Ferguson.

It is a truth universally acknowledged that inflation of just under 2% is a good thing.

Well, you'd be forgiven for thinking so anyway. The number seems to crop up whenever a central banker makes a policy decision.

Take two examples from this month alone. In mid-September, European Central Bank President Mario Draghi announced an interest rate cut and the resumption of a government debt-buying program. Justifying his decision, he said the policies would remain in place "until we have seen the inflation outlook robustly converge to a level sufficiently close to, but below, 2%."

Barely a week later, on the other side of the Atlantic, Jay Powell, the chairman of the Federal Reserve, also decided to cut lending rates. In doing so, he lamented that "inflation continues to run below our symmetric 2% objective."

Such announcements are dutifully reported by journalists like me who pay little attention to how inflation became the cornerstone of monetary policy in the first place and why, since it did, everyone seems to be fixated on 2%. 

To understand this commonly accepted but rarely questioned state of affairs, we must cast our minds back more than a century to examine the rise and fall of another mechanism supposed to ensure fiscal stability: the gold standard.

Gold standard

By 1900, most developed economies around the world had pegged the value of their currency to a specific weight in gold. This made it easy to trade and kept prices relatively stable.

The system worked well for a while but came under severe strain during World War I, when many countries detached themselves from the gold standard and started printing money in order to pay for arms and labor they couldn't otherwise afford. Unsurprisingly, this led to a collapse in price stability.

The gold standard was called into question again during World War II, which left the United States with an enormous trade surplus and consequently in possession of most of the world's gold reserves.

This led to the decision in 1944 to peg other major currencies to the dollar, which alone remained fixed to gold. The idea was that this would restore the stability formerly offered by the gold standard.

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But this too proved problematic.

During the costly Vietnam war, the dollar began to lose value. This was a source of annoyance to other nations, whose economies were recovering but whose currencies remained pegged to the dollar, which in turn was fixed to gold.

It all came to a head in 1965, when French President Charles de Gaulle sent his navy to the United States with the order to convert his country's dollars into gold. Other countries followed suit and American gold reserves declined dramatically. In 1971, US President Richard Nixon banned countries from converting their dollars into gold, thus erasing all vestiges of the old gold standard.

With the shimmering metal no longer the hallmark of monetary stability, central banks sought out alternative ways of ensuring fiscal stability. Inflation, both readily observable and capable of being shaped by intervention, became the focus of attention.

In the early 1990s, New Zealand, Canada and the United Kingdom became the first countries to set inflation targets. By 1998, the European Central Bank had adopted an inflation goal of just under 2% and in 2012, the US Federal Reserve did the same.

Magic number

So why the obsession with 2%? In truth, there's no simple answer. In fact, I would go as far as to say the figure has a less-than-solid foundation.

To some extent, it's a chicken-and-egg situation. The main power central banks have is over interest rates. To boost inflation, they lower rates. But there's only so low they can go without severely punishing people for doing nothing with their money. So they want to keep inflation at a rate that avoids the need for negative interest rates. For no immediately apparent reason, consensus has emerged around 2% as the magic number. Other advocates of the 2% target may simply argue that it reflects a reasonable and sustainable upward trajectory.

Some distinguished economists dispute that. In an opinion piece published by Bloomberg, former Federal Reserve Chairman Paul Volcker writes of the 2% inflation target:

"I know of no theoretical justification. It's difficult to be both a target and a limit at the same time. And a 2% inflation rate, successfully maintained, would mean the price level doubles in little more than a generation."

Other arguments against putting a number on what the ideal inflation rate should be point to the limitations of the pricing indexes that measure it and the fact that history shows that sustained growth is possible without inflation.

Despite these solid arguments, the central bankers of today continue to deem inflation of 2% to be the gold standard of economic health. Persistently, they fall short of their target. 

I can only imagine the kind of economic utopia they believe it represents.

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