If you’ve been following the news from the Federal Reserve, you’re likely to have heard about their often-stated goal of reducing inflation to 2%. But why does the Fed aim for this specific level of inflation?
In their own words: “The Federal Open Market Committee (FOMC) judges that inflation of 2 percent over the longer run, as measured by the annual change in the price index for personal consumption expenditures, is most consistent with the Federal Reserve’s mandate for maximum employment and price stability. When households and businesses can reasonably expect inflation to remain low and stable, they are able to make sound decisions regarding saving, borrowing, and investment, which contributes to a well-functioning economy.”
They go on to point out that while high inflation can be a burden to many families, inflation that’s too low can weaken the economy. The general idea is that there’s a sweet spot for inflation that works best for everyone. But how did they arrive at the figure of 2%?
It wasn’t our Fed that originated the 2% inflation target. It was first developed by the Reserve Bank of New Zealand in 1989. They started with a target of 0-1% but decided that was a bit too low. Wanting to account for potential calculation errors, they shifted – somewhat arbitrarily – to 2%. Despite the lack of science behind it, the 2% target quickly spread to central banks in Britain, Canada, Australia and Sweden, who found the idea of a target appealing.
The Fed didn’t jump on board immediately. They resisted setting firm targets until January 2012, when they finally officially adopted the 2% inflation target under then-Chair Ben Bernanke. Bernanke’s goal was to make the calculations and actions of the Fed more transparent to the public.
But a desire for transparency leaves one obvious question unanswered. Why did the Fed decide not to make their inflation target zero? There are three key reasons experts commonly offer:
Since early 2022, the Fed has been sharply focused on reducing inflation back down to the 2% target. Getting there is likely to take a while longer, and the last leg of the journey might be the hardest. This has led some to ask why the Fed doesn’t spare themselves some trouble and raise the inflation target a little.
However, Fed Chair Jerome Powell has repeatedly stated how important he believes sticking to the 2% target is right now, including in his semiannual testimony to the US Senate Banking Committee.
But if raising the target today seems too opportunistic to be acceptable, what about changing it down the road? In 2019, the Federal Reserve started the practice of having regular comprehensive and public reviews of their monetary policy framework – the strategies, tools and communication practices they use to do their job. The next one comes up in 2024-25.
Our colleagues in Goldman Sachs Research recently weighed in on the future of the Fed’s 2% target. They give three reasons for doubting the Fed will raise this inflation target, even in the next framework review.
First, Fed leaders have expressed doubts about whether they have the right to raise the target without congressional approval.
Second, the Fed declined to raise the target at its last framework review, even though it seemed like the most straightforward solution to their problems during that period. This suggests there is strong resistance within the central bank.
Third, one of the potential costs of a higher inflation target is that when inflation is high enough to be noticed, it might become more volatile and more at risk of becoming entrenched in expectations. Fed officials could conclude that if circumstances beyond their control (like supply shocks) are occasionally going to push inflation well above target, it’s better to start lower than higher to reduce the risk of inflation rising high enough to be noticed in a way that changes inflation psychology.
A current and a former Fed official recently suggested changing the target to a range around 2%, such as 1.5-2.5%. But Fed officials rejected that idea in the last framework review because they worried that implying 1.5% is good enough could increase the risks of having inflation fall too low.
However, officials could reconsider the idea in the next review. A range would recognize the limited control any central bank can really have over inflation.
TL;DR: Our colleagues in Research think the Fed is likely to maintain their 2% target. But if core PCE inflation (the Fed’s preferred inflation measure) falls to 2.5%, they doubt the Fed will have much appetite for any futher policy moves that could risk causing a recession, just to push the rest of the way to 2%.
This article is for informational purposes only and is not a substitute for individualized professional advice. Articles on this website were commissioned and approved by Marcus by Goldman Sachs®, but may not reflect the institutional opinions of The Goldman Sachs Group, Inc., Goldman Sachs Bank USA, Goldman Sachs & Co. LLC or any of their affiliates, subsidiaries or divisions.