As the U.S. Federal Reserve kept its benchmark federal funds rate unchanged at its most recent policy meeting, ending a streak of ten successive rate hikes, it reaffirmed its commitment “to return inflation to 2 percent over time.” Meanwhile the latest Consumer Price Index (CPI) report for May showed that the annual inflation rate had cooled to 4 percent, still well above the Federal Reserve’s stated long term target of 2 percent. Given how widespread the adoption of the 2 percent inflation target is, not just by the Federal Reserve, but also by central banks across the globe, it is worth exploring the origins of it. Interestingly, central bankers did not always have a 2 percent inflation target, or any specific target for that matter. While maintaining price stability, along with low unemployment, has long been the Federal Reserve’s core mandate, prior to the 1990s, it did not have a set numeric inflation target, nor did other central banks. When the Federal Reserve battled the last major bout of inflation in the United States in the late 1970s and 1980s, raising its target funds rate to over 19 percent, it did not have a publicly-declared numeric inflation target.
The 2 percent target widely adopted by central banks today originated from New Zealand, and surprisingly it came not from any academic study, but rather from an offhand comment during a television interview. During the late 1980s, New Zealand was going through a period of high inflation. In 1988, inflation had just come down from a high of 15 percent to around 10 percent. New Zealand’s finance minister, Roger Douglas, was pressed during a television interview about whether the government was satisfied with the now lower—albeit still high—level of inflation. Douglas replied that he was not, saying that he’d ideally want an inflation rate of between zero to 1 percent. At the time there was no set target and the remark was completely off the cuff. But now that it had been made by the nation’s finance minister, the Reserve Bank of New Zealand felt it had to work out a specific target. It determined that there tended to be an “upward bias” in inflation calculations and estimated that this bias in New Zealand was around 0.75 percent, which it rounded to 1 percent, providing a target boundary of 2 percent. Once set, it virtually became gospel among central banks. Canada and England soon adopted 2 percent as their inflation target, as did other central banks. The Federal Reserve never adopted an official numeric target during the period in which so many other central banks did so. The 2 percent target was officially adopted in January 2012 under the leadership of then- Chair Ben Bernanke.
Despite coming about somewhat accidentally, there are reasons why 2 percent (rather than zero) is a reasonable inflation target. Firstly, as mentioned before, it is difficult to measure inflation precisely and there is an inherent “upward bias” in inflation measures, particularly the CPI, meaning true inflation is likely lower than what is measured by the CPI, although the BLS has made several adjustments in an effort to reduce the “upward bias” to CPI. A slightly positive inflation target also leaves the Federal Reserve room to cut interest rates to stimulate the economy in the event of a recession. Having a slightly positive rate also provides a buffer against deflation, which could risk a deflationary spiral and thus be even more harmful for the economy than inflation. For these reasons, a positive but still relatively low inflation target seems reasonable.
Still, because the 2 percent number is not strictly scientific, critics contend that central bankers can fixate too much on inflation at the cost of other economic indicators such as unemployment rate and economic growth when they set it as a hard target. There is no doubt that inflation remains a challenge in the post-Covid recovery and needs to be tackled in the months to come. However, the latest CPI report showed that U.S. inflation had cooled from its peak of over 9 percent last year to around 4 percent in May. The Fed itself projects that inflation could cool to around 3-3.5 percent by the end of the year. If that happens, some question if it worth raising the target federal funds rate further—risking recession and job losses—in order to bring inflation down further to a target rate that is somewhat random. Some experts, like former International Monetary Fund Chief Economist Olivier Blanchard, have suggested a higher inflation target of 3 or 4 percent. Others say that the Fed could consider going back to its goal of price stability without a specific inflation target. They point to Former Federal Reserve Chair Paul Volcker, who is renowned for fighting inflation aggressively by raising interest rates to over 19 percent over four decades ago but did not have a set inflation target in mind. When Volcker’s term ended in 1987, inflation was still at over 4 percent.
The Federal Reserve has recently moved away from a “hard” 2 percent target to a more flexible “average of 2 percent over the long run.” This means that the Fed would tolerate some periods of inflation above 2 percent to offset periods when inflation was below 2 percent. Even if one agreed that a 2 percent inflation target, even a flexible one, should be reconsidered, it may be unwise for the Federal Reserve to completely abandon this target right now. The Federal Reserve remains locked in a fight to bring down inflation from still-elevated levels. One of the Federal Reserve’s main aims is to keep inflation expectations anchored in the public. Completely abandoning an inflation target in the middle of a battle against high inflation might do the opposite, thus raising people’s long-term inflation expectations. Even if the Federal Reserve does rethink its 2 percent target inflation rate, it must wait until after the current bout of inflation has been dealt with before doing so.
This post was written for the Council on Foreign Relations’ Renewing America Initiative—an effort established on the premise that, for the United States to succeed, it must fortify the political, economic, and societal foundations fundamental to its national security and international influence. Renewing America evaluates nine critical domestic issues that shape the ability of the United States to navigate a demanding, competitive, and dangerous world. For more Renewing America resources, visit https://www.cfr.org/programs/renewing-america and follow the initiative on Twitter @RenewingAmerica.