Chapter 3 3.8

Why 2.0% Inflation Target?

Understanding the global consensus on 2.0% inflation targets and why Japan adopted this framework in 2013

Introduction

For decades, Japan was famous for the opposite of inflation: deflation, a persistent fall in prices that stifled growth and increased the real burden of debt. In 2013, the Bank of Japan (BOJ), in coordination with the government, announced a radical policy shift: it would do whatever it took to achieve a 2% inflation target.

This 2% figure isn't arbitrary. It represents a global consensus among major central banks (like the U.S. Federal Reserve and the European Central Bank) as the "goldilocks" rate for inflation—not too hot, not too cold. This section explains the theory behind inflation targeting, why 2% became the magic number, and how this target became the central pillar of modern Japanese monetary policy.

Key Concepts

1. The Theory of Inflation Targeting

Before the 1990s, central banks often targeted other things, like the money supply or the exchange rate, with mixed results. Inflation targeting emerged as a more successful framework for several key reasons:

  • Anchoring Expectations: The most important job of a central bank is to manage expectations. When businesses and households trust that inflation will remain stable at 2%, they can make long-term plans. Businesses can invest, and workers can negotiate wages, without fear of their purchasing power evaporating (high inflation) or their debts becoming unmanageable (deflation).
  • Credibility and Transparency: An explicit target makes the central bank's goal clear to the public. It can be held accountable, which builds credibility.
  • Price Stability for Investors: For bond investors, stable inflation is crucial. A bond's (nominal) yield is made up of two main components: the real interest rate (your actual profit) and expected inflation. If inflation is volatile and unpredictable, the value of your future returns is a gamble. A credible 2% target makes JGBs a more stable and predictable asset.

2. Why 2% Specifically?

The 2% target is a balancing act between the dangers of 0% and the dangers of (for example) 4%.

Why Not 0%? A 0% target is dangerously close to deflation.

  • The Deflation Trap: If inflation is 0%, any small economic shock can tip the economy into deflation (falling prices). Deflation is economically disastrous because it encourages people to hoard cash (why buy today when it's cheaper tomorrow?) and dramatically increases the real burden of debt, leading to defaults and bankruptcies.
  • Measurement Bias: Economic statistics aren't perfect. Most economists believe that standard inflation measures (like the Consumer Price Index or CPI) slightly overstate true inflation. For example, they struggle to capture quality improvements (your new phone costs the same but is much better). A measured inflation of 2% might mean "true" inflation is closer to 1%. A measured 0% would mean true deflation.
  • Policy "Headroom": To fight a recession, central banks cut interest rates. The "real" interest rate is the nominal rate minus inflation. If inflation is 2%, a 0% nominal rate gives a real rate of -2%, which is stimulative. If inflation is 0%, a 0% nominal rate is a 0% real rate, giving the bank less power.

Why Not 4%? While 4% provides a large buffer against deflation, it's considered too high to be "stable."

  • "Menu Costs": At 4% inflation, businesses have to change their prices more frequently, which is costly.
  • Erosion of Savings: Higher inflation more quickly erodes the value of savings, which can be politically unpopular and distort investment decisions.
  • Un-Anchoring: A 4% target might be seen as "soft" on inflation, leading people to suspect it could creep up to 5% or 6%. The 2% level is low enough to be perceived as "price stability" by the public.

3. Japan’s Deflation Experience

Japan's "Lost Decades" (roughly 1991-2011) were defined by a crippling deflationary spiral. After its asset bubble burst, Japan experienced falling prices and stagnant growth. This deflation was toxic:

  • It locked in a "deflationary mindset" where no one expected wages or prices to rise.
  • It made Japan's massive government debt more burdensome each year.
  • It proved incredibly difficult to escape. Conventional monetary policy (like 0% interest rates) was "pushing on a string"—it wasn't enough to make people spend.

4. The 2013 Abenomics Adoption

The 2% target was the cornerstone of "Abenomics," the economic program launched by Prime Minister Shinzo Abe. In January 2013, the government and the BOJ issued a "Joint Statement" committing to this target.

This was a "regime change" moment. The BOJ, under new Governor Haruhiko Kuroda, unleashed massive monetary stimulus (Quantitative and Qualitative Easing, or QQE) with the explicit goal of shocking the system and breaking the deflationary mindset. The target was no longer just a vague goal; it was the central bank's entire mandate.

5. Implications for JGB Markets

The 2% inflation target is the single most important variable for understanding the JGB market.

  • Policy = The Target: All BOJ policy tools—from QQE to Yield Curve Control (YCC) to negative interest rates—were designed to achieve this target.
  • Yields and Expectations: The price of JGBs (and thus their yield) is driven by the market's belief in whether the BOJ can or will hit 2% inflation. For years, the market was skeptical, so the BOJ had to use its tools to force yields down.
  • The Future: Current debates about whether 2% is still appropriate (or achievable) given Japan's demographics are central to the future of BOJ policy and JGB pricing. Any signal that the BOJ is changing this target will send shockwaves through the market.

References and Further Reading

Official Sources:

Academic Research:

  • Bernanke, Ben S. "Inflation Targeting: Lessons from the International Experience." Princeton University Press (1999)
  • Svensson, Lars E.O. "Inflation Targeting." NBER Working Paper No. 16654 (2010)