The mouse that roared: New Zealand and the world’s 2% inflation target

WELLINGTON, New Zealand, Jan 30 (Reuters) – More than 30 years ago, some relatively young central bank and treasury economists in New Zealand were grappling with how to control two decades of double-digit inflation in an economy less than 1% the size of its American counterpart.

If they asked, they told everyone that the rate should be much lower, say – about 2% – and then aim for that?

“I think it was a bit of a shock to everybody,” said Roger Douglas, then Labor finance minister who pioneered the policy alongside the Treasury and Reserve Bank of New Zealand (RBNZ). “I just announced it would be 2% and it stuck.”

This is how inflation targeting came about.

Since its arrival in 1990, the phenomenon of a 2% inflation target has floated from Wellington around the world, becoming the accepted norm among central banks large and small to underpin public expectations of what inflation should be. But price hikes caused by the COVID-19 pandemic will test their commitment in the coming months, as inflation will remain stubbornly above 2% for some time.

With some observers questioning whether that level would hold today, the debate over whether to remove the shocks to growth and employment from the high interest rates used by central banks to reach it in most cases – inflation-targeting pioneers New Zealand supports.

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In fact, former RBNZ chief economist and senior official Arthur Grimes, considered one of the key architects of the policy, wants the target to include a lower range.

“Zero is an obvious kind of destination — it basically says that, on average, prices in 10 years should be about the same as they are now. Why would you want anything else?” he said.

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When New Zealand was the first country to mandate inflation targeting, the upper limit was 2% and the lower limit was just 0%. Inflation was 7.6% at the time, but averaged above 10% in the 1970s and 1990s, and few thought the target was realistic.

Former RBNZ economist Michael Reddell, who headed the economics department’s monetary policy unit at the time, said: “There was some intense internal debate, and I don’t think everyone was convinced that we should be aiming lower.”

“It wasn’t the most scientific process in the world… our resources were limited. No one had done it before us,” he added.

Inflation targeting was accompanied by aggressive monetary tightening, with the 90-day rate rising to 15% in 1990. A year later, inflation fell to 2% and New Zealand’s inflationary expectations quickly adjusted to the new paradigm.

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But from 1989 to 1994, the economy stagnated, unemployment rose to double digits, and there were heavy short-term costs for businesses and workers.

Since then, the target has been moved twice, first to a range of 0 to 3% and then in 2002 to a range of 1% to 3%.

The decision – and the resulting policy – is largely driven by politics.

Governments went to great expense to get votes due to inflation. Former finance minister Douglas asked the central bank and the Treasury to initiate policies to prevent this from happening again.

At first there was some debate about whether interest rates or the money supply should be the target, but it was decided that the latter target was better: inflation.

“They did all the hard work and I got the reputation of being the most hated person in New Zealand,” Douglas said.


But for New Zealanders accustomed to high inflation, 2% seemed incredible. Don Brash, then RBNZ governor and later leader of the opposition National Party, said he held grueling meetings with everyone from news organizations to grassroots bodies to get them on board.

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New Zealand faces rising unemployment, with wages falling short of the cost of living. Reuters reported that in 1994, 13 protesters were arrested after being dragged from the lobby of the RBNZ in Wellington and demanding higher inflation from the central bank.

“The lesson from our history is that if you don’t want to hurt the real economy, don’t let inflation happen in the first place. Because the way back from inflation to sub-inflation always involves a loss of output.” Graham Scott, Chancellor of the Exchequer from 1986-1993.

After the changes were made, New Zealand remained in the spotlight. It has better attracted economic event speakers and policy architects to major gatherings, including the US Federal Reserve’s annual symposium in Jackson Hole, Wyoming. Other central bankers wanted to understand what had happened.

“‘How did we do it?’ “It became a bigger question than ‘what did we do,'” Douglas said. “I mean, most people didn’t really take issue with what we were doing, but they wondered how we got away with it.”

Report by Lucy Kramer; Edited by Dan Burns and Paul Simao

Our standards: Thomson Reuters Trust Principles.


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