Both the Federal Reserve and the ECB target an inflation rate of 2%. Inflation is defined as the rising price level of all goods & services in an economy. It means that for the same basket of goods and services, you pay more than last year. This sounds undesirable: if you pay more for the same products, your purchasing power has decreased (assuming constant income & wealth). This is obviously undesirable from an individual consumer’s point of view. Then why is an inflation rate of 2% considered as desirable by the Fed and ECB, you might ask. Good question!

Deflation

To understand why, we must first understand the opposite – deflation. In times of deflation, the basket of goods & services you buy every month becomes cheaper (as opposed to more expensive in the case of inflation). From an individual consumer’s perspective, it may now make sense to delay some expenditures, as the same item will cost less next year. For example, given a deflation rate of 5%, a car which costs $10,000 this year will cost only $9,500 next year. Knowing this, most prospective buyers will prefer to wait one year to buy the car for $9,500.

Most economists consider delayed purchases like this as negative given one person’s expenditure is another person’s income. If all economic agents would delay their expenditures, the total economic output, measured as Gross Domestic Product (GDP), would decrease year-on-year. This can lead to a self-reinforcing negative economic spiral: lower economic output implies lower income for businesses, which is likely to lead to lower investments, layoffs, and more expenditure delays. This is likely to lead to further GDP contraction, more deflation, i.e. a negative economic spiral.

This negative feedback loop is exactly why the Fed and ECB target 2% inflation. A recent example of an economy suffering from deflation is Japan. From 1995 until 2013, prices decreased almost every year, taking its toll on the economy. In the same period, real GDP growth amounted to 18%, vs. 58% for the United States. Real wage growth amounted to 1%(!), compared to 28% in the United States. The period in the 90s when the deflation spiral began, is now dubbed “the lost decade” in Japan.

Conclusion

In contrast, an inflation rate of 2% is considered by the Fed, ECB and most economists to be a happy medium between deflation and excessive inflation. Businesses and consumers are not incentivized to delay expenditures given prices are increasing year-on-year (in contrast to a deflationary environment). On the other hand, the inflation rate is moderate enough to not diminish consumers’ purchasing power at an unacceptable rate. As a result, consumers and businesses can make balanced decisions between saving, investing and spending. This happy equilibrium can lead to a virtuous cycle, opposite to the negative deflationary spiral: as businesses and consumers pick up spending, GDP grows, which leads to increased employment, investments and new economic activity.