The curious history of the Federal Reserve's 2% inflation targeting, explained

The 2% inflation target is key to the Federal Reserve’s vision for stable prices in the U.S. economy, according to the Federal Reserve Bank of St. Louis.

Canada, Australia, Japan and Israel are among the many economies that include 2% in their inflation rate targets, according to the International Monetary Fund.

But, “the 2% inflation target, it’s relatively arbitrary,” Josh Bivens, director of research at the Economic Policy Institute, told CNBC.

Then, where exactly did this 2% inflation rate dream originate?  

“You would think that … maybe somewhere in the Bible, God says he wants 2% inflation,” Laurence Ball, professor of economics at Johns Hopkins University and a consultant for the International Monetary Fund, quipped to CNBC.

“It was invented, oddly, in New Zealand,” said Ball.

So, CNBC called up some New Zealand economists.

“We led the way in inflation targeting,” Arthur Grimes, professor of wellbeing and public policy at Victoria University, told CNBC.

In the late 1980s, New Zealand was facing incredibly high inflation when freshly minted Ph.D. economist Grimes started his work at the central bank, which at the time was not independent from the government.

“We were saying, ‘OK, if we have independence, what should we target? Interest rates or the money supply?'” Grimes said.

“And I just one day, I said, ‘Well, actually, what are we trying to achieve? We’re trying to achieve price stability. Why don’t we just have an inflation target?'”

The Reserve Bank of New Zealand Act of 1989 introduced inflation targeting and that policy is being used today in economies around the world. Canada announced its inflation target in 1991, and the United Kingdom followed suit in 1992. Then, Sweden and Finland declared inflation targets in 1993, according to the Organization for Economic Cooperation and Development.

It took until 2012 for the U.S. to declare its 2% inflation rate target.

And since then, there has been controversy over whether that target is justified.

For example, in 2017, some economists wrote a letter to the Federal Open Market Committee, making the case for a higher target.

“There’s no evidence that 3% or 4% inflation does substantial damage relative to 2% inflation,” said Ball, one of the economists who signed that letter.

Now, though, as the world shifts to a new post-pandemic normal, the inflation targets of central banks across the world have faced new scrutiny.

“It is, I think, an error to say 2% is somehow magically the right number,” former Federal Reserve Bank of Kansas City president Thomas Hoenig told CNBC.

Watch the video above to learn more about the twisty tale of 2% inflation targeting, why some economists vote for lower targets while others argue for a higher target, the implications of targeting inflation at all and whether this monetary policy will meaningfully change anytime soon.