Why Does the Fed Target 2% Inflation?

Since January 2012, the Federal Reserve has maintained a target of 2 percent inflation for the US economy.  The target allows the Fed to perform its congressionally mandated jobs of maintaining price stability and maximum employment.  Before the 1970s, economists believed inflation and unemployment had a permanent negative correlation so that low inflation and low unemployment could not be achieved at the same time.  

However, the 1970s oil shock brought on a period of high inflation and unemployment known as stagflation.  With the high rates of the 1970s, the Fed needed a new way to control inflation.  At the time, most central banks used currency pegging to control inflation by controlling the value of currency.  Relatively stable currency values acted as a nominal anchor for prices.  A nominal anchor is a variable set by central banks that helps firms set prices.  Maintaining a stable nominal anchor allows the Fed to preserve price stability.  However, as the oil shock continued, the difficulty of maintaining the value of the dollar increased, and inflation could not be controlled.  Other countries that pegged their currencies to the value of the dollar experienced inflation as a result.  Pegging a nation’s currency means surrendering monetary policy to whatever the currency is pegged to.  Thus central banks switched their tactics, first targeting the expansion of the money supply to match the growth of prices.  This proved too difficult as demand for money became increasingly unstable, mainly due to innovations in financial instruments.  Finally, central banks began to target the rate of inflation directly, using monetary policy to push the economy toward the target over the medium term.  

Inflation targeting has proved effective as countries that practice it appear to fare better in economic crises.  The US economy experienced four recessions between 1970 and 1982.  After that period, it experienced longer and more prosperous periods of growth.  Additionally, inflation targeting helps anchor future expectations of inflation among individuals and firms.  These expectations can be as important as the rate of inflation itself because they are used to make business decisions.  The Fed’s announcement of its inflation target served the dual purposes of increasing transparency in its actions as well as reducing public uncertainty and providing an anchor to future expectations of inflation.

The Fed can gauge expectations of inflation through surveys such as the University of Michigan Survey of Consumers or through financial markets.  Surveys tend to be less accurate and do not provide the Fed a clear idea of what policies it should take to bring expectations in line with its target.  Financial market measurements such as the price of Treasury Inflation Protected Securities can be more useful.  The difference in price between inflation protected securities and unprotected securities represents the expectation of future inflation among those buying government bonds.  The Fed would like expectations of future inflation to be in line with its target in order to maintain price stability.  However, expectations have been below the target since 2014.  

Because expectations are too low, the real rate of inflation as forecast by the Fed is also below its 2 percent target.  When forecast inflation is too low, the Fed will try to raise it by lowering the Federal Funds Rate.  This will increase the money supply and make borrowing cheaper.  Therefore, the Fed hopes, consumers will spend more, driving prices up.  Inflation rises as the overall price level in the economy increases.  The Fed uses the headline Personal Consumption Expenditure (PCE) price index to measure inflation.  If prices for consumer goods increase by 2% on average annually, inflation will be on target.  Similarly, if inflation is too high, the Fed will raise the Federal Funds Rate to reduce the money supply and discourage consumption in order to keep prices more stable.

If price stability is the Federal Reserve’s goal then why does it choose a positive rate of inflation, not zero?  First, headline PCE and other price indices often overstate inflation by 1-2 percentage points.  A PCE measurement of 2% inflation is therefore likely to mean prices are actually stable.  Because of the inherent uncertainty in measuring inflation, the Fed also chooses a positive inflation target in order to avoid deflation.  Any given rate of inflation is considered less harmful to the economy than an equivalent rate of deflation.  When prices for consumer goods are going down, people choose not to spend because they can save money by spending later.  Lowered demand leads to even lower prices and thus even lower demand.  Therefore, the Fed would rather err on the side of positive inflation than risk a deflationary spiral.  Finally, inflation rates tend to correlate with interest rates.  This means that having a positive rate of inflation is associated with having positive interest rates within the economy.  In the event of a recession such as the one induced by the COVID-19 pandemic, the Fed wants interest rates to be positive so that it can cut them if needed.

Inflation targeting is one part of the Federal Reserve’s efforts to maintain price stability and full employment.  Inflation is more directly related to monetary policy than the maximum level of employment so the Fed chooses to target inflation rather than a specific unemployment rate, but by smoothing out uncertainties in inflation, the Fed creates conditions for businesses to hire more workers, reducing unemployment.  Inflation targeting has contributed to smoothing out the business cycle, the primary goal of the study of macroeconomics.  Understanding how and why the Fed targets 2 percent inflation leads to a better understanding of how central banks apply macroeconomic theory to improve real living standards around the world.

By Maxwell Qian

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