The story behind the 2% inflation target

How we got here and why it’s still relevant

April 27, 2021

Share this article

If you’ve been following the news about inflation, you’re likely to have heard that the UK inflation rate is currently above the 2% target. But why do various central banks aim for this specific level of inflation? And how did they arrive at this figure?

How 2% became the magic number

In 1989, New Zealand became the first country to set a formal inflation target of between 0 and 2%. This development came after periods of high inflation globally and high levels of economic instability. A 0-2% range was seen at the time as an appropriate and pragmatic means to maintain greater economic control and have enough room to encourage economic growth.

This initiative was seen as successful and, over time, the 2% target became a tried, tested and trusted number. It has now been adopted by multiple governments globally, with central banks including The European Central Bank, The Federal Reserve, and the Bank of England working to help hit this target through monetary policies.

Why the UK target isn’t 0%

So, why doesn’t the UK government make its inflation target zero? There are three key reasons experts commonly offer:

Room to cut interest rates: Higher inflation rates tend to go hand-in-hand with higher interest rates. If interest rates stay above 0%, this leaves room for the Bank of England or to cut the Bank Rate, which in turn influences the interest rates charged by commercial banks, when it needs to. This can help to stimulate spending, as the cost of goods and services is lower and typically credit costs you less. You can read more about the relationship between interest and inflation here.
Insurance against deflation: Deflation is a reduction in the amount of money in a country's economy so that prices fall or remain the same, and it can sometimes be even more harmful to an economy than inflation. Setting a slightly positive goal can provide a buffer against deflation.
Measurement bias: It’s hard to measure inflation precisely and traditional indices such as the Consumer Price Index tend to deliver numbers a little higher than the true rate. So, when the indices say inflation is at 2%, it is probably lower.

Why is the UK inflation rate above target?

The UK inflation rate continues to remain higher than the 2% target due to a number of significant challenges and recent shocks to the economy, that in turn contribute to increases in the interest rate. These include:

Covid-19 pandemic: Staying at home often meant people were generally buying more goods than services which caused issues with supply, leading to a surge in pricing.
Russia’s invasion of Ukraine: This led to an increase in the price of essential goods such as oil, gas and some foods.
Lower amount of people available to work: Many economies, including the UK, have been impacted by some changes to the workforce. This is, in part, connected to the Covid-19 pandemic. To attract applicants, businesses (most notably those in the services sector) have had to offer higher wages and this has led to an increase in some costs.

Given inflation seems to have run away from the 2% target, getting the inflation rate back down to the target could take a bit of time. This has led some to ask why the government doesn’t spare itself some trouble and raise the inflation target a little, say to 3%?

In the most recent monetary policy remit, the Chancellor made it clear that the 2% inflation target is important for price stability and that it’s useful to have a forward-looking target that doesn’t just consider the short-term trends. Among other points, he stressed that the UK government believes that low and stable medium-term inflation is “an essential pre-requisite for economic prosperity".

The final word

While high inflation can be a significant challenge to consumers, as it generally means the cost of living has increased, inflation that’s too low can weaken the economy.

Over time, a 2% target has emerged as a potential sweet spot to maintain price stability and support economic growth. Despite the economic and social difficulties of the past few years for the UK and other countries, this 2% aspiration has continued to drive central banking thinking and, looking ahead, is unlikely to change.

Room to cut interest rates: Higher inflation rates tend to go hand-in-hand with higher interest rates. If interest rates stay above 0%, this leaves room for the Bank of England or to cut the Bank Rate, which in turn influences the interest rates charged by commercial banks, when it needs to. This can help to stimulate spending, as the cost of goods and services is lower and typically credit costs you less. You can read more about the relationship between interest and inflation here.
Insurance against deflation: Deflation is a reduction in the amount of money in a country's economy so that prices fall or remain the same, and it can sometimes be even more harmful to an economy than inflation. Setting a slightly positive goal can provide a buffer against deflation.
Measurement bias: It’s hard to measure inflation precisely and traditional indices such as the Consumer Price Index tend to deliver numbers a little higher than the true rate. So, when the indices say inflation is at 2%, it is probably lower.

The content in this article is for information only and is not advice. It uses sources from Marcus by Goldman Sachs and third parties. All content in this article was accurate on the date of publication shown above.