BIS central bankers’ speeches  1  Chart 2  Four years after the financial crisis engulfed the world, a European version has now emerged. Both market participants and the authorities failed in their assessments after the introduction of a single currency. Prior to the introduction of the Economic and Monetary Union, there were wide differences between interest rates facing different European countries, which primarily reflected different inflation expectations across countries. But through the 1990s, long-term interest rates drifted down to German levels. Over the next 10 years, sovereign interest rates were fairly similar – and very low – for all euro area countries despite wide differences in debt levels, budget deficits and growth rates. Market participants did not take into account differences in sovereign creditworthiness. Sovereign debt was treated as virtually risk-free, both in the markets and by the authorities. The period contrasts with the recent two to three years during which interest rates on sovereign debt have widened sharply. For many countries, interest rates have reached very high levels. In retrospect, we see that market participants failed in their risk assessment through the ten years following the introduction of the euro. Economic policy also failed. EU rules relating to budget deficits and public debt were disregarded early on when Germany and France exceeded the limits they had so eagerly advocated when the European Monetary Union was established. Other countries followed their example. Low interest rates made it easy to finance deficits by issuing new debt.
But why choose a target of 2 per cent? The reason why the inflation target in most countries has been set at 2 per cent or close to this is more the result of chance and circumstances than science. When an inflation target was introduced in Sweden, the Riksbank assessed that underlying inflation was at that time 2 per cent. Several other industrial nations had already chosen 2 per cent. The aim in Sweden then became to keep inflation at around this level. BIS central bankers’ speeches  1  Most central banks probably considered, quite simply, that an inflation rate of 2 per cent was a reasonable level to strive for – sufficiently low for people not to worry about when making financial decisions, but not too low. There are three important reasons why the target is higher than zero. •  The first concerns statistical measures of inflation being assumed to overestimate actual price increases. This is partly because it is difficult to distinguish price increases due to better quality from price increases per se. If one has an inflation target of zero, and the inflation rate measured is zero in accordance with the target, there is thus a risk that inflation will actually be below zero because the quality improvements have been underestimated and thus the prices have fallen in relation to the level of the quality.