'No need to sack the governor' and other reasons for the RBA's inflation target

The Reserve Bank has lifted interest rates to their highest level in 18 years, delivering another blow to indebted households in its efforts to squash inflation.

RBA governor Michele Bullock says inflation is too high and it has to be dragged back down into the RBA's 2 to 3 per cent target range.

Headline inflation in Australia is rising at an annual pace of 4.3 per cent at the moment.

"We are not looking to tip the economy into recession if we can avoid it, but we do need to get inflation down, and we do have excess demand at the moment, so that is the key," Ms Bullock said on Tuesday.

But why does the RBA think annual inflation of 2 to 3 per cent is optimal?

Why does it target that particular range for inflation?

Why not inflation of less than 2 per cent? Or slightly higher at 3–4 per cent?

For a number that's so consequential, its origins are surprisingly imprecise.

The RBA adopted its inflation target in the early 1990s.

It copied the idea from New Zealand, which pioneered the concept and became the first country in the world to formally adopt inflation targeting as we know it in 1990.

But the RBA didn't copy New Zealand's model completely.

New Zealand originally picked an inflation target of 0–2 per cent, and senior officials at the RBA thought that was misguided, and wanted a different target.

Stephen Grenville, a former RBA deputy governor, recalled the history in 2023 as part of the RBA's oral history collection of interviews.

Dr Grenville worked at the RBA between 1982 and 2001 (his last five years as deputy governor).

"Any inflation target that contemplates getting to zero — or would think that being at, or near, zero is a good thing — just misunderstands the nature of inflation," he said.

"Economies work much better with a little bit of inflation so that relative prices can change, and in any case, quality improvements and a whole lot of those technical issues mean that zero makes no sense.

"So that [lower] end of the New Zealand target was wrong.

Dr Grenville said there were other reasons why the RBA didn't like New Zealand's 0–2 per cent target.

One reason was that New Zealand's original target was going to have "electric fences" on it — the edges, zero and two, were "very clear penalty areas" — which didn't make sense to RBA officials.

"You could have 1.9 per cent [inflation] and that was OK, but if you slipped over to 2.1 [per cent], various bad things happened, and at least initially there was talk that the governor would be sacked," Dr Grenville recalled.

In the end, New Zealand didn't go ahead with that harsh plan, but they still saw it as a very bad thing if they ever recorded an inflation number bigger than 2 per cent.

"[W]hereas we thought the proper way to think about an inflation target was like an archer's target: that an archer always aims for the centre [and] doesn't expect to hit the centre of the bullseye all the time, but consistently aims for the bullseye," Dr Grenville said.

"[We] thought the right answer was to just mention a single number — which would be the centre of the target — and there wouldn't be any electric fences.

"The presumption, of course, would be the further away you were from the bullseye, the more you needed to do as the more you were off target.

"So it was a much more graduated thing that you could be off the bullseye, and no need to sack the governor," he said.

That's how the RBA stumbled upon its "2–3 per cent" target.

Dr Grenville said in the early 1990s, after more than a decade of high inflation and economic disruption, RBA officials didn't think they could get Australia's annual inflation down to 2 per cent sustainably, but they still wanted to be ambitious.

"We knew we'd had 'the recession we had to have' and we were going to make a lot of progress on inflation, but we didn't think we'd get much below 3 [per cent]," he said.

"We thought to mention 2 [per cent], which by then some other central bankers were talking about, and of course was the top of the New Zealand target.

"[So] 2 would be too ambitious, but 3 would sound like we weren't trying hard enough, so we suggested 2 to 3 [per cent, but] not as a range, and this was something we had a lot of trouble explaining.

"We didn't think we would stay within 2 to 3 [per cent], because we really thought of it as — I think Glenn [Stevens] invented the term — a 'thick point'.

"We just wanted people to be saying: well, if we had a number starting with 2, most of the time we would regard that as a satisfactory outcome.

"So that's one advance, as we saw it, over the New Zealand inflation targeting," he said.

Dr Grenville said the RBA also included a time dimension in its inflation target to allow for the fact that economies moved in cycles over many years.

"We somehow had to make sense of a single objective, so if people said to us 'don't you care about unemployment?', we would say 'this is where unemployment fits into our single objective'," he said.

"The critical thing was the time dimension, and I think we were clearly the first to grapple with that idea that you had to get a time dimension into the inflation target.

"The time dimension we introduced was we wanted to get the 2 to 3 [per cent] over the course of the cycle, and that fitted with the idea that, yes, monetary policy does have some influence on the shape of the cycle.

"[And] over time, over the first four or five years of inflation targeting as it spread through more and more countries, everyone adopted our formula of 'over the course of the cycle', or gave themselves some time to get inflation back where it had to be," he said.

Those are the fascinating origins of Australia's 2–3 per cent inflation target, a concept that is highly consequential in Australia's economy.

Yesterday, after the RBA lifted interest rates for the fifth time in 2026, governor Michele Bullock acknowledged that home loan borrowers would feel more pain from the higher rates.

But she said if inflation didn't come down, the pain of prolonged high inflation would be worse.

And she said the RBA now expected headline inflation to peak at 4.5 per cent at the end of this year [up from 4.3 per cent currently] and to not return to the RBA's 2–3 per cent inflation target band until late 2027.