2%: The Inflation Target That Started With a Guess

Most major central banks on earth are currently making decisions that affect your job, mortgage, savings, and the price of everything you buy, all in pursuit of a single number: 2%.

If you asked most economists or central banks where that number came from, they would tell you it represents the optimal balance between price stability and economic growth, the product of decades of research by some of the world's leading economic minds.

But they would be incorrect.

So Where Did 2% Actually Come From?

In 1988, New Zealand's inflation rate had just fallen below 10% for the first time in two years. The country had been through a rough period, a 10% VAT introduction in 1986 drove inflation to 18.9% by mid-1987 and the government was under pressure to get it under control.

On April 1st 1988 (yes, that date is correct) Roger Douglas, New Zealand's Finance Minister, went on TV to discuss monetary policy. The interviewer asked "Is the government satisfied now that inflation has come down?". "No", Douglas replied. He said "he would ideally want to see inflation somewhere around 0% or 0% to 1%". The remark was entirely off the cuff, with no research behind it or model that justified it. The Finance Minister made up a number that sounded responsible and moved on.

Don Brash had just become Governor of the Reserve Bank of New Zealand and now had to make his Finance Minister's quote into an actual policy framework. His team estimated New Zealand's inflation measurement bias was around 0.75%, rounded it up to 1%, and added it to Douglas's 0-1% range, arriving at a maximum target boundary of 2%. Brash's colleague Michael Reddell later admitted the process "wasn't ruthlessly scientific."

The idea spread the way ideas spread in central banking, via direct conversations between staff. The Bank of Canada consulted Reserve Bank of New Zealand staff directly before adopting the target in 1991. Lord Mervyn King, then Chief Economist of the Bank of England, later said the idea of an inflation target "was certainly influenced by conversations with the Reserve Bank of New Zealand staff." Canada adopted it in 1991, the UK followed in October 1992 after the pound was forced out of the European Exchange Rate Mechanism on Black Wednesday, then Sweden followed months later after the krona suffered the same fate. Brash then presented the framework at the Jackson Hole conference in August 1994, the Federal Reserve formally adopted a 2% target in 2012, more than twenty years after a New Zealand Finance Minister made up a number on TV. In Brash's own words, the figure was "plucked out of the air to influence public expectations."

How the Narrative Was Built Around It

Once 2% became the target, the intellectual justification followed. This is not unusual, policy often precedes theory, but it created a situation where the evidence was built to support a conclusion already reached rather than to find the right answer. Three main justifications emerged:

Measurement bias. Consumer price indexes tend to overstate actual inflation slightly because they don't fully account for quality improvements or substitution effects. An official reading of 2% probably reflects true inflation closer to 0.5-1%, so 2% is close to zero without the risks of actual deflation.

Wage flexibility. In a zero inflation world, cutting labour costs means cutting actual salaries which is a painful and politically difficult process. Small positive inflation gives employers another option: just don't raise salaries to match inflation. The spending power of the wage falls without the actual salary reducing, workers accept it more readily than an outright pay cut even though the outcome is very similar.

The zero lower bound. If central banks target 2% inflation, nominal interest rates in normal times sit around 4-5%, giving them room to cut significantly when recessions hit before reaching zero and running out of conventional tools. A 0% target would mean normal rates of only 2-3%, leaving almost no wiggle room when they need it most.

These are all reasonable arguments, none of them are why 2% was originally chosen though. They were put in place after the fact to justify an ad-hoc number that someone made up on TV.

Why it is Now Being Questioned?

The challenge to the 2% target is not coming from fringe economists, Olivier Blanchard served as Chief Economist of the IMF for a decade and Lawrence Summers was US Treasury Secretary. Both, alongside Jordi Gali and Adam Posen, have argued publicly that 2% is too low and it should be raised to 3%.

The core argument is that the zero lower bound problem has proven worse than expected. The theory was that a 2% inflation target would keep nominal rates high enough that central banks would rarely need to cut to zero. In practice though, the Fed, the ECB, and the Bank of Japan all spent years pinned at or near zero despite targeting 2% inflation showing the buffer was insufficient.

Central banks cut interest rates to stimulate the economy in a downturn, but they can only cut to zero, you cannot have a negative interest rate in practice. If your starting point before a recession hits is a rate of only 4-5%, you have limited room to manoeuvre. A 3% inflation target rather than 2% would push that starting point up by one percentage point, giving central banks more power to get a crisis under control when it arrives.

Blanchard has refined his position over time, initially calling for 4% in 2010. Later research suggested 4% is where consumers start getting genuinely anxious about inflation and price stability as a psychological anchor begins to break down. 3% appears to be the level that provides more policy room without triggering that instability. In a 2023 debate with Summers he said: "I don't think any economist can argue against" a 3% target if you were to design the system from scratch today.

The counter-argument, made by Ben Bernanke, Janet Yellen, and John Taylor, is about credibility. Central banks spent decades establishing 2% as an anchor for inflation expectations, changing it risks unmooring those expectations and signalling the target is negotiable. If people believe the target will be raised whenever it proves inconvenient, it loses its power to shape behaviour.

So What Is Happening Right Now

On May 28th the Bureau of Economic Analysis released the April 2026 US PCE data, headline PCE came in at 3.8% YoY, up from 3.5% in March. Core PCE (which removes food and energy), rose to 3.3% from 3.2%. Both headline and core PCE are moving in the wrong direction, with them being almost double the 2% target. Real disposable income fell 0.5% in April and personal saving rate dropped to 2.6%, the lowest in almost four years. Americans are currently burning through savings to cover the gap between wages and prices.

The Fed is holding its interest rate at 3.5-3.75%. The April FOMC meeting produced the most divided vote since October 1992, with eight members for holding, four dissenting. Three of the four dissenters opposed not the rate decision itself but the easing bias in the statement, meaning they don't want the Fed to even signal potential future cuts while inflation is running at 3.8%.

Kevin Warsh, who replaced Jerome Powell in May 2026, said that "cutting interest rates is not possible with the current state of inflation and the ongoing war" and that "addressing the current inflation may necessitate raising interest rates." A Fed chair openly discussing rate rises while inflation sits at 3.8% and the debate about whether the target should be 3% rather than 2% shows the current framework is being stress-tested in real time.

The inflation driving these numbers is not a demand-side problem. The Iran conflict sent Brent crude from $70 to over $115. Energy alone accounted for around half of April's monthly CPI increase, with a 5.6% monthly gain in prices at the pump. The remaining pressure came from food (grocery prices up 0.7% in a single month) and shelter costs, which rose at double their normal monthly rate. Airline fares, up 20.7% YoY, show energy costs being passed through into broader services.

As of publication, the US and Iranian negotiators have agreed a 60-day ceasefire extension though Trump has not yet signed off on the deal, and both sides exchanged fire last week. If the ceasefire holds and oil prices fall from current levels, the near-term energy-driven inflation pressure eases.

What Changing the Target Would Mean

No central bank has officially moved its target to 3%, several are tolerating above-target inflation for longer without saying so. If they did move it formally, the implications would be significant and they would not fall equally across assets.

Central banks would stop tightening earlier and start cutting sooner. Mortgage holders on variable rates benefit, along with businesses that have floating rate debt. Governments carrying large debt loads benefit as inflation erodes the real value of existing debt, when prices rise faster than debt grows, the debt-to-GDP ratio falls without even paying a penny back. Growth assets like equities and real estate, tend to perform better in moderately higher inflation environments.

Anyone holding cash or fixed income sees purchasing power erode faster. Savers on fixed interest rates see real returns fall, pension funds with long-duration fixed income liabilities take hits to their real value and workers on fixed salaries who don't negotiate annual increases see the buying power of their wages decline more quickly.

Higher inflation functions as a regressive transfer, wealthier households hold more of their wealth in property, equities and businesses, that appreciate with inflation. Lower income households hold more in cash and depend more heavily on their wages. A move from 2% to 3% would create a wealth transfer, from savers to asset owners and from people on fixed incomes to people with debt.

My Thoughts

The 2% target is not going to be formally changed by Central Banks anytime soon. The credibility argument is true and they know that moving the goalposts would be damaging regardless of the underlying logic.

What is more likely, and arguably already happening, is informal tolerance of inflation running slightly above 2% for extended periods. The April PCE print of 3.8% with a Fed holding rates and discussing potential rises rather than cuts is not the policy environment the 2% framework was designed to produce.

For investors the practical outcome is what matters, 2% in name only and something higher in practice changes the potential for different assets. Assets like equities and commodities hold up much better, the companies that thrive in a persistently above-target inflation world are different from the ones that thrived when the target was being met. Energy producers, commodity companies, and consumer staples brands with genuine pricing power tend to outperform. Long-duration growth stocks (whose value depends on cash flows years into the future) get hit hardest as higher rates compress their multiples. Long-term bonds lose value in real terms and cash sitting in savings accounts sees its buying power eroded.

The uncomfortable truth is that the foundation of the most important number in global monetary policy was never as solid as the institutional confidence around them suggested. The next time you see an article or report from a central bank explaining why 2% inflation is the precise and optimal goal, it is worth remembering where the number actually came from.

Ticker Thoughts is independent analysis. No positions held in the securities mentioned at time of publication.