Where did the 2% inflation target come from?

Financial expert Peter McGahan looks at what happens when prices go up - and down

Workers, savers and small businesses are among the winners in the Budget
Price stability allows governments, companies and families to know what money they need for whatever their needs are (Peter Byrne/PA)

Asking where the 2% inflation target came from is an interesting question, but the bigger ask might be why central banks have an upward target for inflation at all?

It would seem to be a good idea if you cared about society that you would target for prices to fall rather than rise, wouldn’t it?

Falling prices would mean we have more money to spare, we would be able to work less, we could retire earlier, you wouldn’t need so much money, and you wouldn’t need for your pension to grow as much? All seems logical to me?

The 2% target is quite recent, and the first country to formally adopt it was, amazingly, New Zealand. They were followed three years later by the Bank of England in 1992.

The theory is that any target creates price stability, and a two per cent growth is a moderate level of growth and assists the economy, whereas deflation is bad for it. Let’s dig deeper.

Price stability is the primary target of course as it allows governments, companies and families to know what money they need for whatever their needs are.

For example, a heightened demand for oil might send all prices through the roof. Most ‘things’ need to be delivered. Food, overseas imported products, and others all have a price that is affected by, say, oil rising, or falling.

If these prices swayed wildly, those using them may be unlikely to have the cash flow for those spikes in prices. The consequence? Economic collapse.

So, by keeping price increases lower and controlled, we avoid high inflation which erodes your buying power with your money and makes central bank decision making much easier by eradicating unnecessary distortion.

Having the -2% to +2% target gives flexibility for the central bank. Having that range means the bank can take a different view based on the economic conditions, and where the inflation issue is outside of the monetary policy of the bank, for example, a war, covid bottlenecks etc.

The greatest benefit is that it explains to financial markets, the public and the public sector what the clear goals are so they know what to expect from the Bank.

So why not opt for falling prices ie: deflation?

Funnily enough, if prices are perceived to be falling, people stop buying and wait to see how far they will fall before they step in. The result? Demand falls and so, therefore do prices. Because people stop buying products or services, there is no need for them to be created, those people lose jobs, there is less money in circulation due to unemployment, prices fall further, companies go under, companies can’t fund pensions due to profitability... I’m sure you get the carnage that could be caused by what we refer to as a negative feedback loop.

Why would you invest into a project or building if you thought the costs to build it would be falling as would the asset value’s future price? Investment and jobs would fall off.

If you have deflation, the real value of your debt actually increases, whereas inflation erodes it. Moreover, if we have deflation, wages would need to fall as profitability may be lower, and so those people lower their spend and the above loop happens again.

Peter McGahan (Mal McCann)

So, by targeting a positive, but controlled rate, banks create the buffer that is clear and communicated, which greases the wheels to nudge along spending, economic growth and investment.

Companies become profitable, their share prices go up, your pension which is invested in them goes up, and if the economy is well known and trusted, external investors (overseas funds and governments) invest, which drives your share prices higher, giving you more money to spend.

If there is an imbalance, the reverse can easily become true. There you have it!

  • Peter McGahan is chief executive of independent financial adviser Worldwide Financial Planning, which is authorised and regulated by the Financial Conduct Authority. If you have a financial question for Peter, call 028 6863 2692.