Why 2% is the inflation goal for most central banks, not 0%

Most leading central banks set a medium-term inflation goal of about 2% per year. Yet why do monetary authorities not aim for 0%, which would leave prices flat over time? The answer rests on the influence of inflation expectations on economic choices, the dangers that come with deflation, and the constraints on monetary policy.

Having an inflation objective gives households, companies and financial markets a concrete benchmark. That is significant, since what people anticipate about prices feeds into their actions. In setting prices and discussing wages, firms weigh the rate of inflation they expect. Employees include anticipated movements in living costs when they bargain over pay. Consumers base spending, saving and credit decisions partly on expected inflation, and markets build those expectations into bond yields and other asset valuations.

If people have faith that the central bank will hold price growth near its stated goal, expectations tend to stay anchored in that area. That can stop short-lived price shocks from becoming entrenched inflation.

Consider a rise in oil prices. Energy costs moving higher can lift headline inflation for a while. Should households and firms trust the central bank to return inflation to around 2%, they might hold back from insisting on lasting pay increases or pushing prices up sharply in case of more inflation. As a result, the original shock has a smaller chance of rippling across the economy.

The reverse can occur once trust in the inflation goal weakens. Workers anticipating continued price rises may ask for bigger pay increases. Companies then see labour bills climb and may lift their own prices, adding to inflation. Breaking that pattern could require more forceful rate increases from the central bank.

An inflation goal functions as an anchor for expectations. It cannot remove shocks from the economy, but it can keep those shocks from feeding on themselves.

What makes 2% preferable to 0%?

A moderately positive inflation rate is preferred for a number of reasons. One is that it provides a cushion against deflation. Deflation refers to a sustained decline in the overall level of prices. While cheaper prices may look attractive to consumers at first, broad and lasting deflation can inflict serious damage on the economy.

If households anticipate additional price declines, they can delay buying. Faced with softer demand, companies may trim investment, scale back output and shed staff. The resulting income losses hit demand again, intensifying the downward pull on prices and activity.

Deflation also makes debt heavier in real terms. Borrowers among households and firms still owe the same nominal sum, regardless of declining prices for what they sell or earn. Revenues or wages may fall while repayments stay fixed, making outstanding loans harder to service.

The result can be a damaging cycle in which lower prices, weaker demand, falling incomes and financial strain reinforce one another. A 2% inflation target offers a safety margin. Price growth moves around the objective when demand shifts, supply disturbances occur or other shocks hit. At a 0% target, even a modest negative shock could tip the economy into deflation right away. A positive goal leaves central banks greater scope to smooth those swings and stay clear of deflation.

The link between inflation and real interest rates

A further rationale for aiming at positive inflation is that it keeps monetary room available for stimulus through lower real rates. For economic activity, the nominal rate chosen by the central bank is not all that matters; so does the rate's relationship to inflation. Real interest rates reflect borrowing costs once the loss of purchasing power from inflation is taken into account. As a rough approximation, the real rate equals the nominal rate minus expected inflation.

Whenever inflation runs above the nominal interest rate, real rates turn negative. That lowers the true cost of credit and lightens the real load of outstanding debt, giving a lift to consumption, investment and lending. In the opposite case, with nominal rates above inflation, real rates are positive, so borrowing becomes dearer in real terms and saving looks more attractive than spending. Demand is then likely to be dampened and growth to cool.

Central banks thus steer activity in part by moving nominal rates in relation to expected inflation. In a period of weak growth, a cut in nominal rates lowers real borrowing costs and acts as stimulus. But that room shrinks when nominal rates are already near zero.

That is the point at which a positive inflation goal matters. With expectations fastened near 2%, nominal rates can typically sit higher over time than under a 0% inflation target, other things equal. That extra headroom lets authorities cut nominal rates in a slump, pushing real rates down and easing monetary conditions.

A 0% objective would offer a thinner buffer against deflation. Should inflation expectations drop below zero with nominal rates close to zero too, real rates could climb even with no move in nominal rates. Conditions would then tighten at exactly the moment more support might be required. That was the experience of the Great Depression, when deflation pushed real rates up and intensified the slump.

A positive inflation target lowers that danger. It offers no assurance that real rates will always be sufficiently low to boost growth, but it does cushion deflation risk and gives policymakers more leeway to reduce real borrowing costs in a downturn.