New Zealand and the world’s goal of 2% inflation: the mouse that roared
More than 30 years ago, young central bankers and Treasury economists in New Zealand were trying to figure out how to stop two decades of double-digit inflation in an economy that was only 1% as big as the U.S. economy.
What if, they wondered, they simply told everyone that the rate should be much lower, say 2%, and then worked to achieve that?
Roger Douglas, who was the Labour Party’s finance minister at the time and worked with the Treasury and Reserve Bank of New Zealand (RBNZ) to start the policy, said, “I think it was a bit of a shock for everyone.” “I just said it would be 2%, and it seems to have stuck.”
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Inflation targeting was born from this.
Since 1990, when it started in Wellington, New Zealand, the 2% inflation target has spread around the world and become the standard for central banks, big and small, to set public expectations about what inflation should be. But the price spikes caused by the COVID-19 pandemic will test their commitment to it in the coming months, as inflation is likely to stay above 2% for a while.
Some people aren’t sure if that level is still relevant today, and most of them are debating if it should be raised to protect growth and jobs from the high interest rates that central banks are using to reach that level. However, the inflation-targeting pioneers in New Zealand are sticking to it.
In fact, Arthur Grimes, a former chief economist and senior official at the RBNZ who was seen as one of the policy’s main creators, would like the target to include a lower range.
“Zero seems like a good place to aim for, since it means that on average, prices in 10 years should be about the same as they are now.” “Why would you want to do something else?” he said.
Graphic: Inflation is still higher than expected everywhere. https://www.reuters.com/graphics/GLOBAL-CENBANKS/INFLATION/lbvggoqwgvq/chart.png
“MOST HATED MAN”
When New Zealand became the first country to require inflation targeting, the upper limit was 2% and the lower limit was just 0%. At the time, inflation was at 7.6%, but it had been above 10% on average from 1970 to 1990, so not many people thought the goal was achievable.
Michael Reddell, a former RBNZ economist who was in charge of the economics department’s monetary policy section at the time, said, “There were some pretty nasty internal debates.” I don’t think everyone was convinced that we should be aiming for something as low as we were.
“It wasn’t the most scientific way to do things, but we didn’t have many options.” “We were the first ones to do this,” he added.
After the inflation target was set, aggressive monetary tightening took place, and by 1990, 90-day rates had risen to 15%. After a year, inflation had dropped to 2%, and people in New Zealand quickly adjusted to the new situation.
But there were big short-term costs for businesses and workers. Between 1989 and 1994, the economy stalled and the unemployment rate rose into the double digits.
Since then, the goal has been changed twice. First, it went from 0% to 3%, and then in 2002, it went from 1% to 3%.
Politics were the main reason for the decision and the policy that came out of it.
Inflation rose because governments went on spending sprees to win votes. Douglas, who used to be the minister of finance, asked the central bank and the Treasury to come up with a plan to make sure that didn’t happen again.
At first, there was a debate about whether interest rates or the amount of money should be the goal. However, it was decided that the real goal should be inflation.
“They did all the hard work, and all I got was the glory and the title of being the most hated man in New Zealand,” Douglas said.
BE ON THE LOOKOUT
But for people in New Zealand who were used to high inflation, 2% seemed impossible. Don Brash, who was the governor of the Reserve Bank of New Zealand (RBNZ) at the time and later became the leader of the opposition National Party, said he met with news organisations and grassroots groups for long hours to get them on board.
Unemployment was going up in New Zealand, and wages weren’t keeping up with the cost of living. In 1994, Reuters reported that 13 protesters were pulled out of the foyer of the RBNZ in Wellington and arrested after demanding that the central bank let inflation rise.
“History shows that if you don’t want inflation to hurt the real economy, you shouldn’t let it happen in the first place.” Because the only way to get from embedded inflation to low inflation is to lose output, From 1986 to 1993, Graham Scott was the secretary of the Treasury.
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After the changes were made, New Zealand became the centre of attention. It got better economic speakers to speak at events, and the people who made the policy were invited to big events like the annual symposium of the U.S. Federal Reserve in Jackson Hole, Wyoming. Others in the central bank wanted to know what had happened.
“‘What did we do?’ became less important than ‘how did we do it?'” Douglas said. “Most people didn’t really disagree with what we were doing, but they did wonder how we got away with it.”