What Is Inflation Targeting And Why Does It Matter? There's a number you could call the most important number for the economy. It's the Federal Reserve's inflation target. The story of how it came to be is a bit random, and begins in New Zealand.

What Is Inflation Targeting And Why Does It Matter?

What Is Inflation Targeting And Why Does It Matter?

  • Download
  • <iframe src="https://www.npr.org/player/embed/674036708/674036709" width="100%" height="290" frameborder="0" scrolling="no" title="NPR embedded audio player">
  • Transcript

There's a number you could call the most important number for the economy. It's the Federal Reserve's inflation target. The story of how it came to be is a bit random, and begins in New Zealand.


Last week, when Fed Chair Jay Powell signaled that interest rate rises might slow down, the stock market shot up. But he also made another announcement - one that got less attention but is even more fundamental to our economy. He said America is near the 2 percent inflation target. Why does that matter? Darian Woods from NPR's Planet Money podcast team tells us the unlikely but true story of the 2 percent target.

DARIAN WOODS, BYLINE: The idea started on a small island nation at the other side of the world, New Zealand. In the 1970s and '80s, New Zealand was getting crushed by high inflation - like, 15 percent. So the government sent a young economist named Arthur Grimes around the world to see how other countries kept inflation in check. He came back and said, nobody has a good plan. Let's try something totally new.

Here's how it went. Inflation is how much prices are rising, and that's partly caused by what people expect prices to be in the future. So when businesses think that competitors and suppliers are going to raise prices, they'll be more likely to raise their prices, too. It's a cycle.

So Grimes says the government should just pick a level of inflation, tell the country and then drive the whole economy towards that target.


ARTHUR GRIMES: There was no such thing as inflation targeting at the time. It was only after New Zealand had done it that that term was actually invented.

WOODS: So in 1990, New Zealand picked a cap of 2 percent inflation and gave themselves three years to achieve it. And they even came up with a slogan.


GRIMES: Zero to two by '92. Sounds good, doesn't it?

WOODS: It didn't go so well at first. Grimes and his colleagues were seeing unemployment numbers go up and up and up. They were facing all kinds of pressure to go back on their plan. But they held firm. And by the time the economy recovered, inflation was under control. Inflation targeting worked.

GRIMES: Oh, I think it was a big success.

WOODS: The world's biggest economies started copying New Zealand - Canada first, the U.K., then Australia. And they all announced this publicly. But here in the United States, it went a little differently.


SEBASTIAN MALLABY: What happened was really rather strange.

WOODS: This is Sebastian Mallaby. He's the author of a biography of former Fed Chair Alan Greenspan. He surfaced the bizarre way the U.S. Federal Reserve settled on 2 percent. The decision was made at a central bankers' meeting in 1996.


MALLABY: It's almost like they didn't come up with it. They just kind of landed on it by some quirk of how the conversation flowed.

WOODS: Alan Greenspan asked Janet Yellen, another central banker, if she thought there should be some kind of inflation target.

MALLABY: And she didn't want to give a clear answer.

WOODS: So she parried the question back to Alan Greenspan.

MALLABY: And he sort of mumbled and waffled.

WOODS: Greenspan says, 0 percent. And Yellen says, measurement problems. You really mean 2 percent, right?

MALLABY: Then it kind of stuck.

WOODS: The next day, Alan Greenspan, the Fed chair at the time, tells everyone at the meeting to keep it a secret.


MALLABY: He said, I will tell you that if the 2 percent inflation figure gets out of this room, it is going to create more problems for us than I think any of you might anticipate.

WOODS: The Fed unofficially targeted 2 percent inflation for 16 years before admitting it publicly. And inflation has stayed quiet this whole time, maybe even a bit too quiet.


MALLABY: There's no magical logic that justifies 2 percent more than 1 percent or 3 percent. And yet, we've made a kind of fetish of this 2 percent target.

WOODS: But 2 percent is still the target, affecting decisions on things like interest rates, money supply - how America runs its whole economy. Darian Woods, NPR News.


Copyright © 2018 NPR. All rights reserved. Visit our website terms of use and permissions pages at www.npr.org for further information.

NPR transcripts are created on a rush deadline by an NPR contractor. This text may not be in its final form and may be updated or revised in the future. Accuracy and availability may vary. The authoritative record of NPR’s programming is the audio record.