Where Did the 2 Percent Inflation Target Come From?

Imagine a clause in your employment contract that says your pay will be cut by two percent every year, forever, and that the cut will never appear on a pay stub. You would not sign it. Yet a version of that clause sits underneath every dollar you earn and save, and it is described on the evening news as a sign of a healthy economy.

The Federal Reserve aims for inflation of 2 percent a year.¹ Most of us hear that number so often that it sounds like a constant of nature, the way water boils at 212 degrees. It is worth asking where it came from, because the answer is not what you would expect.

A Number Chosen in New Zealand

In the late 1980s New Zealand was coming off years of double-digit inflation. During a 1988 television interview, the country's finance minister said he wanted inflation down around zero to one percent. That remark became the starting point for the Reserve Bank of New Zealand, which in 1990 became the first central bank in the world to adopt a formal inflation target, set at zero to two percent.²

Don Brash, who ran the bank at the time, later described the origin plainly:

"It was almost a chance remark. The figure was plucked out of the air to influence the public's expectations."

Don Brash, former Governor, Reserve Bank of New Zealand²

The policy worked at what it was built for. New Zealand's inflation came down, and over the next decade central banks in Canada, Britain, Sweden, and elsewhere adopted targets of their own. The United States made it official late: the Federal Reserve formally announced its 2 percent goal in January 2012.³

So the number that governs the value of your savings was not handed down by economic theory. It was a practical figure that one country picked, that seemed to work, and that everyone else copied.

What 2 Percent Does Over a Working Life

Two percent sounds like almost nothing, and in any single year it nearly is. The cost shows up in the compounding. James Lavish, a former Wall Street portfolio manager, ran the numbers most people never see: at 2 percent a year, your purchasing power falls by about 45 percent over a 30-year career and about 64 percent over a 50-year adult lifetime.⁴ A dollar saved at 25 buys roughly half as much at 55, and that is when the policy succeeds exactly as designed.

It has not held to the design. Across the full record since 1913, US consumer prices have risen by about 3.2 percent a year on average.⁵ That is how a dollar from 1913 came to buy about three cents' worth of goods today. For a more recent measure, $10,000 set aside in 2010 bought about $6,900 worth of goods by 2024.

Two Kinds of 2 Percent

There is a coincidence here worth noticing. The world's supply of gold also grows by roughly 1.5 to 2 percent a year, as miners bring new metal out of the ground.⁶ For most of history, that slow and steady growth is a large part of why gold served as money.

On paper the two figures look alike. They are built on opposite principles. Gold's rate is a constraint: nobody can raise it in a crisis, however good the reason. The central bank's rate is a policy: it holds until the people who set it decide otherwise. In 2020 and 2021 the supply of dollars grew by roughly 40 percent in two years, and official inflation reached 9.1 percent in 2022.⁷ A constraint cannot do that. A policy can.

Who Comes Out Ahead

The case for a positive target is a serious one, and it deserves a fair hearing. Economists who support it argue that a little inflation gives central banks room to cut interest rates in a downturn, discourages people from sitting on cash while the economy stalls, and makes it easier for wages to adjust. Those are real considerations, and many thoughtful people hold them.

The other side of the ledger is who bears the cost. New money does not arrive everywhere at once. It enters through banks, governments, and large borrowers, who spend it at yesterday's prices. By the time it reaches wage earners and retirees, prices have already moved. Economists call this the Cantillon Effect, after the eighteenth-century writer who first described it. Steady inflation also lightens every debt and shrinks every savings account, so it rewards borrowing and penalizes saving, year after year.

"The rich ruleth over the poor, and the borrower is servant to the lender."

Proverbs 22:7

The proverb describes an order in which the saver stands on firm ground and the borrower is the one at risk. A currency designed to lose value each year turns that order around. The household that does what every generation before was told was wise, spending less than it earns and putting the rest away, is the household that pays.

The Question Underneath

You can believe the 2 percent target is sound policy or a slow tax, and reasonable people land on both sides. What is harder to dispute is the structure: a small group decides how fast your money loses value, they chose the rate themselves, and they can change it when they judge the moment calls for it. The honest question is not whether 2 is the right number. It is whether the value of your savings should depend on anyone's choice of number at all.

The free first lesson of the course starts there. It walks through what money is supposed to do, why gold held that job for five thousand years, and what changed in 1971.