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The 2% Inflation Target Where Did It Come From?

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https://www.ecb.europa.eu/mopo/strategy/pricestab/html/index.en.html

The definition of price stability Quantitative definitionWhile the Treaty clearly establishes the primary objective of the ECB, it does not give a precise definition of what is meant by price stability.

The ECB’s Governing Council has announced a quantitative definition of price stability:
  • "Price stability is defined as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%."
The Governing Council has also clarified that, in the pursuit of price stability, it aims to maintain inflation rates below, but close to, 2% over the medium term.

https://www.chicagofed.org/publications/speeches/our-dual-mandate-background

In 1977, Congress amended The Federal Reserve Act, stating the monetary policy objectives of the Federal Reserve as:

"The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates."

This is often called the "dual mandate" and guides the Fed's decision-making in conducting monetary policy. On January 25, 2012, the Federal Open Market Committee (FOMC) released the principles regarding its longer-run goals and monetary policy strategy.

The statement notes that:

“The FOMC is firmly committed to fulfilling its statutory mandate from the Congress of promoting maximum employment, stable prices, and moderate long-term interest rates. The Committee seeks to explain its monetary policy decisions to the public as clearly as possible. Such clarity facilitates well-informed decision making by households and businesses, reduces economic and financial uncertainty, increases the effectiveness of monetary policy, and enhances transparency and accountability, which are essential in a democratic society.

Inflation, employment, and long-term interest rates fluctuate over time in response to economic and financial disturbances. Moreover, monetary policy actions tend to influence economic activity and prices with a lag. Therefore, the Committee's policy decisions reflect its longer-run goals, its medium-term outlook, and its assessments of the balance of risks, including risks to the financial system that could impede the attainment of the Committee's goals.

The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate. Communicating this inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored, thereby fostering price stability and moderate long-term interest rates and enhancing the Committee's ability to promote maximum employment in the face of significant economic disturbances.

http://www.bankofengland.co.uk/monetarypolicy/Pages/framework/framework.aspx

The inflation target
The inflation target of 2% is expressed in terms of an annual rate of inflation based on the Consumer Prices Index (CPI). The remit is not to achieve the lowest possible inflation rate. Inflation below the target of 2% is judged to be just as bad as inflation above the target. The inflation target is therefore symmetrical.

If the target is missed by more than 1 percentage point on either side – i.e. if the annual rate of CPI inflation is more than 3% or less than 1% – the Governor of the Bank must write an open letter to the Chancellor explaining the reasons why inflation has increased or fallen to such an extent and what the Bank proposes to do to ensure inflation comes back to the target.

A target of 2% does not mean that inflation will be held at this rate constantly. That would be neither possible nor desirable. Interest rates would be changing all the time, and by large amounts, causing unnecessary uncertainty and volatility in the economy. Even then it would not be possible to keep inflation at 2% in each and every month. Instead, the MPC’s aim is to set interest rates so that inflation can be brought back to target within a reasonable time period without creating undue instability in the economy.

This 2% inflation target which is clearly the scientific mantra at the main central banks, where did it come from? Are there economic papers which state 2% over the long term is sustainable? I'm guessing not because it fails the exponential problem, but if so where the hell did this 2% figure come from. Is it assumed that the vast majority of people will feel 2% is stable as they really don't grasp the maths and the long term compound effect behind it?

Does anyone know where this great target came from? It is like the alcohol limit and was a finger in air moment?

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a number whereby savings can be confiscated by the tax called inflation, at a rate that is slow enough not to be noticed yet fast enough to accrue wealth to those issuing the money.

Another expression is to "boil the frog slowly"

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https://www.ecb.europa.eu/mopo/strategy/pricestab/html/index.en.html

https://www.chicagofed.org/publications/speeches/our-dual-mandate-background

http://www.bankofengland.co.uk/monetarypolicy/Pages/framework/framework.aspx

This 2% inflation target which is clearly the scientific mantra at the main central banks, where did it come from? Are there economic papers which state 2% over the long term is sustainable? I'm guessing not because it fails the exponential problem, but if so where the hell did this 2% figure come from. Is it assumed that the vast majority of people will feel 2% is stable as they really don't grasp the maths and the long term compound effect behind it?

Does anyone know where this great target came from? It is like the alcohol limit and was a finger in air moment?

The abject failure of the gold standard and the stagflation of the 70/80s.

2% is just a low but positive number, it could equally be not explicity stated (as it didn't used to be at the FED) or close to but less than 2% as in ECB, or symmetric around 2% (+/- 1%) in UK or something else, 4% say or higher if you're an emerging market economy.

The point is whether you have floating exchange rates to absorb external shocks, or floating exchange rates and an inflation target or something else.

What do you mean by "the exponential problem"? It's a % so currency never falls to zero. Today the average wage may be £30,000 (or whatever) whereas in 1694 it may have been 1 groat (or whatever). It doesn't much matter unless you were dumb enough to hoard 1 groat in 1694 and expect it to spend it in 2015 and nobody is that dumb

Edited by R K

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https://www.ecb.europa.eu/mopo/strategy/pricestab/html/index.en.html

https://www.chicagofed.org/publications/speeches/our-dual-mandate-background

http://www.bankofengland.co.uk/monetarypolicy/Pages/framework/framework.aspx

This 2% inflation target which is clearly the scientific mantra at the main central banks, where did it come from? Are there economic papers which state 2% over the long term is sustainable? I'm guessing not because it fails the exponential problem, but if so where the hell did this 2% figure come from. Is it assumed that the vast majority of people will feel 2% is stable as they really don't grasp the maths and the long term compound effect behind it?

Does anyone know where this great target came from? It is like the alcohol limit and was a finger in air moment?

Exponential........2% is 'at the moment' a reasonable/dire accumulation of inflation that will allow the right amount of debt money to drip feed into the system, low productivity growth requires help, debt created today is that help...should balance things out nicely.....as real productivity/real growth (meaning hands on not financial games) lessens more help will be required....what that will be ultimately will boil down to what confidence others hold.

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What do you mean by "the exponential problem"? It's a % so currency never falls to zero. Today the average wage may be £30,000 (or whatever) whereas in 1694 it may have been 1 groat (or whatever). It doesn't much matter unless you were dumb enough to hoard 1 groat in 1694 and expect it to spend it in 2015 and nobody is that dumb

Well the world population is around 7bn. I've read in the past it's growing at 2%, seems a very low number. Apart from the fact that means 140m new people per year.

So in little over 7 years you've added another 1bn people to the worlds population but the economy is only growing at 2%. So more food, more water, more jobs etc.... more resources.

However to add 1bn with 6bn people takes just over 8 years.

This is the exponential function. Population growth at 2% is not sustainable, why on earth would anyone think growth of a £1.4tr economy is?

Chris Martenson explains the exponential problem very well here.

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http://physics.ucsd.edu/do-the-math/2012/04/economist-meets-physicist/

Physicist: [sigh of relief: not a space cadet] Alright, the Earth has only one mechanism for releasing heat to space, and that’s via (infrared) radiation. We understand the phenomenon perfectly well, and can predict the surface temperature of the planet as a function of how much energy the human race produces. The upshot is that at a 2.3% growth rate (conveniently chosen to represent a 10× increase every century), we would reach boiling temperature in about 400 years. [Pained expression from economist.] And this statement is independent of technology. Even if we don’t have a name for the energy source yet, as long as it obeys thermodynamics, we cook ourselves with perpetual energy increase.

Economist: That’s a striking result. Could not technology pipe or beam the heat elsewhere, rather than relying on thermal radiation?

Physicist: Well, we could (and do, somewhat) beam non-thermal radiation into space, like light, lasers, radio waves, etc. But the problem is that these “sources” are forms of high-grade, low-entropy energy. Instead, we’re talking about getting rid of the waste heat from all the processes by which we use energy. This energy is thermal in nature. We might be able to scoop up some of this to do useful “work,” but at very low thermodynamic efficiency. If you want to use high-grade energy in the first place, having high-entropy waste heat is pretty inescapable.

Economist: [furrowed brow] Okay, but I still think our path can easily accommodate at least a steady energy profile. We’ll use it more efficiently and for new pursuits that continue to support growth.

Physicist: Before we tackle that, we’re too close to an astounding point for me to leave it unspoken. At that 2.3% growth rate, we would be using energy at a rate corresponding to the total solar input striking Earth in a little over 400 years. We would consume something comparable to the entire sun in 1400 years from now. By 2500 years, we would use energy at the rate of the entire Milky Way galaxy—100 billion stars! I think you can see the absurdity of continued energy growth. 2500 years is not that long, from a historical perspective. We know what we were doing 2500 years ago. I think I know what we’re not going to be doing 2500 years hence.

Economist: That’s really remarkable—I appreciate the detour. You said about 1400 years to reach parity with solar output?

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Chris Martenson explains the exponential problem very well here.

No he doesn't. He is describing population growth and resources, not nominal price inflation or inflation targetting.

Here's Ben's 2003 speech entitled "A perspective on inflation targetting"

http://www.federalreserve.gov/BoardDocs/speeches/2003/20030325/default.htm

I'm sure you could find many others........

One of the more interesting developments in central banking in the past dozen years or so has been the increasingly widespread adoption of the monetary policy framework known as inflation targeting. The approach evolved gradually from earlier monetary policy strategies that followed the demise of the Bretton Woods fixed-exchange-rate system--most directly, I believe, from the practices of Germany's Bundesbank and the Swiss National Bank during the latter part of the 1970s and the 1980s. For example, the Bundesbank, though it conducted short-term policy with reference to targets for money supply growth, derived those targets each year by calculating the rate of money growth estimated to be consistent with the bank's long-run desired rate of inflation, normally 2 percent per year. Hence, the Bundesbank indirectly targeted inflation, using money growth as a quantitative indicator to aid in the calibration of its policy. Notably, the evidence suggests that, when conflicts arose between its money growth targets and inflation targets, the Bundesbank generally chose to give greater weight to its inflation targets (Bernanke and Mihov, 1997).1

The inflation-targeting approach became more explicit with the strategies adopted in the early 1990s by a number of pioneering central banks, among them the Reserve Bank of New Zealand, the Bank of Canada, the Bank of England, Sweden's Riksbank, and the Reserve Bank of Australia. Over the past decade, variants of inflation targeting have proliferated, with newly industrialized and emerging-market economies (Brazil, Chile, Israel, Korea, Mexico, South Africa, the Philippines, and Thailand, among others) being among the most enthusiastic initiates. Most recently, this policy framework has also been adopted by several transition economies, notably the Czech Republic, Hungary, and Poland.2 Central banks that have switched to inflation targeting have generally been pleased with the results they have obtained. The strongest evidence on that score is that, thus far at least, none of the several dozen adopters of inflation targeting has abandoned the approach.3

Edited by R K

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http://www.peakprosperity.com/crashcourse/chapter-3-exponential-growth

To illustrate this using population: If we started with 1 million people and set the growth rate to a measly 1% per year, we’d find that it would take 694 years before we achieved a billion people. But we’d be at 2 billion people after only 100 more years, while the third billion would require just 41 more years. Then 29 years, then 22, and then finally only 18 years to add another, to bring us to 6 billion people. That is, each additional billion people took a shorter and shorter amount of time to achieve. Here we can see the theme of speeding up.

I thought I'd read it was 2%, but here it's 1%, but the problem ultimately is the same.

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http://www.peakprosperity.com/dr_albert_bartlett

I wish we could get every person to make this mental calculation every time we see a percent growth rate of anything in a news story. For example, if you saw a story that said things had been growing 7% per year for several recent years, you wouldn't bat an eyelash. But when you see a headline that says crime has doubled in a decade, you say “My heavens, what's happening?”

OK, what is happening? 7% growth per year: divide the seven into 70, the doubling time is ten years. But notice, if you want to write a headline to get people's attention, you'd never write “Crime Growing 7% Per Year,” nobody would know what it means. Now, do you know what 7% means?

Let's take an example, another example from Colorado. The cost of an all-day lift ticket to ski at Vail has been growing about 7% per year ever since Vail first opened in 1963. At that time you paid $5 for an all-day lift ticket. What's the doubling time for 7% growth? Ten years. So what was the cost ten years later in 1973? (showing slides of rapidly increasing prices) Ten years later in 1983? Ten years later in 1993? What was it last year in 2003, and what do we have to look forward to? (shows "2003: $80; 2013: $160; 2023: $320; audience laughter)

This is what 7% means. Most people don't have a clue. And how is Vail doing? They're pretty much on schedule.

So let's look at a generic graph of something that’s growing steadily. After one doubling time, the growing quantity is up to twice its initial size. Two doubling times, it's up to four times its initial size. Then it goes to 8, 16, 32, 64, 128, 256, 512, in ten doubling times it's a thousand times larger than when it started. You can see if you try to make a graph of that on ordinary graph paper, the graph’s gonna go right through the ceiling.

..

Well, let’s translate that into the energy crisis. Here’s an ad from the year 1975. It asks the question “Could America run out of electricity?” America depends on electricity. Our need for electricity actually doubles every 10 or 12 years. That's an accurate reflection of a very long history of steady growth of the electric industry in this country, growth at a rate of around 7% per year, which gives you doubling every 10 years.

Now, with all that history of growth, they just expected the growth would go on, forever. Fortunately it stopped, not because anyone understood arithmetic, it stopped for other reasons. Well, let's ask “What if?” Suppose the growth had continued? Then we would see here the thing we just saw with the chess board. In the ten years following the appearance of this ad, in that decade, the amount of electrical energy we would have consumed in this country would have been greater than the total of all of the electrical energy we had ever consumed in the entire proceeding history of the steady growth of that industry in this country.

Now, did you realize that anything as completely acceptable as 7% growth per year could give such an incredible consequence? That in just ten years you'd use more than the total of all that had been used in all the proceeding growth?

Well, that's exactly what President Carter was referring to in his speech on energy. One of his statements was this: he said, “In each of those decades (1950s and 1960s) more oil was consumed than in all of mankind's previous history.” By itself that's a stunning statement.

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No he doesn't. He is describing population growth and resources, not nominal price inflation or inflation targetting.

Here's Ben's 2003 speech entitled "A perspective on inflation targetting"

http://www.federalreserve.gov/BoardDocs/speeches/2003/20030325/default.htm

I'm sure you could find many others........

A 2% growth target is a 2% growth target, it's utterly irrelevant what the subject matter is in the terms of mathematics.

What you are saying is monetary value it totally irrelevant and in X number of years the UK govt will be paying in £1m per week to dole claimants. Insane or logical? You can't beat the maths because ultimately this is where we are heading.

A 2% inflation target means prices are doubling effectively every 35 years. However house prices at 10% are effectively doubling every 10 years. Something will give.

Edited by interestrateripoff

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No he doesn't. He is describing population growth and resources, not nominal price inflation or inflation targetting.

Here's Ben's 2003 speech entitled "A perspective on inflation targetting"

http://www.federalreserve.gov/BoardDocs/speeches/2003/20030325/default.htm

I'm sure you could find many others........

Although communication plays several important roles in inflation targeting, perhaps the most important is focusing and anchoring expectations. Clearly there are limits to what talk can achieve; ultimately, talk must be backed up by action, in the form of successful policies. Likewise, for a successful and credible central bank like the Federal Reserve, the immediate benefits of adopting a more explicit communication strategy may be modest.

:lol::lol::lol:

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note: the 2% refers to the desired growth rate of prices ie. the rate of inflation. That is over and above the growth rate of the economy. That is the swindle.

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note: the 2% refers to the desired growth rate of prices ie. the rate of inflation. That is over and above the growth rate of the economy. That is the swindle.

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Does it not make sense that as the quantity of debt grows exponentially that the rate of interest on that debt must decrease exponentially to keep the system stable.

Zero or even negative interest rates are a dead cirt until the system blows up. It's sensible to keep an eye on inflation, but now the debts so large there is little they can do to influence it without blowing things up.

2% rate hike anyone?

It would be nice to get the big reset out of the way so that I can plan retirement without factoring in currency collapse.

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note: the 2% refers to the desired growth rate of prices ie. the rate of inflation. That is over and above the growth rate of the economy. That is the swindle.

yes.....so what is growth?.....have to spend 2% extra every year or maintain a population growth of 2% that will spend if others cutting back......otherwise create growth via train crashes meaning purposely creating problems to solve. ;)

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He's quite right you know.

http://en.wikipedia.org/wiki/Inflation_targeting

Basically the overall view is they wanted 'price stability' but using a small positive number because effecting price changes in the economy (eg wages in different sectors) is much, much easier to manage than have to deflate people's pay.

And sufficient room to accommodate the business cycle. At least in theory. :unsure:

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Today the average wage may be £30,000 (or whatever) whereas in 1694 it may have been 1 groat (or whatever). It doesn't much matter unless you were dumb enough to hoard 1 groat in 1694 and expect it to spend it in 2015 and nobody is that dumb

How about instead of hoarding the groat you lend it to somebody in the form of, oh I don't know, a mortgage which they use to buy a house. If the central bank then prints and devalues the debt, borrowers might get the idea that this is what will always happen and that borrowing money to buy houses is a one-way bet. You might then get a crazy situation where people will pay essentially any price for housing so long as they can borrow enough money. The cost of a house might go from 3 times salary to 6 times to 10 times to 15 times. You could end up with a situation in which people were devoting huge proportions of their income to paying for housing, crowding out other economic activities, and even small drops in house prices would bankrupt all the banks.

But yeah, other than that it doesn't much matter.

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How about instead of hoarding the groat you lend it to somebody in the form of, oh I don't know, a mortgage which they use to buy a house. If the central bank then prints and devalues the debt, borrowers might get the idea that this is what will always happen and that borrowing money to buy houses is a one-way bet. You might then get a crazy situation where people will pay essentially any price for housing so long as they can borrow enough money. The cost of a house might go from 3 times salary to 6 times to 10 times to 15 times. You could end up with a situation in which people were devoting huge proportions of their income to paying for housing, crowding out other economic activities, and even small drops in house prices would bankrupt all the banks.

But yeah, other than that it doesn't much matter.

Obviously that wouldn't happen because any sensible economy would build enough houses to satisfy demand.

The cost of a house might go from 3 times salary to 6 times to 10 times to 15 times. You could end up with a situation in which people were devoting huge proportions of their income to paying for housing

You example assumes 3 times salary is some natural universal multiple.

People aren't devoting huge proportions of their income to paying for housing. FTBs are paying towards the lowest % of household income for their mortgages as I assume you know full well.

But yeah, apart from that........

Edited by R K

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Obviously that wouldn't happen because any sensible economy would build enough houses to satisfy demand.

You mean like in China which has according to reports 64m empty houses? Although if they don't get used soon they might have fallen down in around 25 years.....

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You mean like in China which has according to reports 64m empty houses? Although if they don't get used soon they might have fallen down in around 25 years.....

You think Chinese house prices are sustainable? okaaaaaaayyy....

(what has this to do with inflation targetting btw?)

Edited by R K

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Some more points on this.

With 2% inflation that means prices double every 35 years.

If house prices grow at 10% per year a £100k in 7 years will be worth £200k, in 14 years £400k, in 21 years £800k and finally after 28 years £1.6m. Just think how all this will boost GDP... Especially if all other inflation is around 2%.

The problem is the bigger the numbers the bigger the numerical increases and soon your talking astronomical numbers.

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