Dolar: How did Fed settle on 2% as target rate for inflation?

What’s so special about the number 2? Quite a lot, if you’re a central banker and that number is followed by a percent sign.

That’s been the de facto or official target inflation rate for the Federal Reserve, as well as the European Central Bank and many similar institutions, since at least the 1990s.

In recent months, inflation has soared around the world, forcing the Fed and its counterparts to jack up interest rates to bring them down to the vicinity of their target level.

As an economist who has studied the movements of key economic indicators like inflation, I know that low and stable inflation is essential for a well-functioning economy. But why does the target have to be 2%? Why not 3%, or even zero?

The U.S. inflation rate hit its 2022 peak in July at an annual rate of 9.1%. The last time consumer prices were rising this fast was back in 1981, more than 40 years ago.

Since March 2022, the Fed has been actively trying to decrease inflation. In order to do this, it has been hiking its benchmark borrowing rate – from effectively 0% back in March 2022 to the current range of 4.25% to 4.5%.

Most economists agree that an inflation rate approaching 8% is too high, but what should it be? If rising prices are so terrible, why not shoot for zero inflation?

One of the Fed’s core mandates, alongside low unemployment, is stable prices.

Since 1996, Fed policymakers have generally adopted the stance that their target for doing so was an inflation rate of around 2%. In January 2012, then-Chairman Ben Bernanke made this target official, and both of his successors, including current Chair Jerome Powell, have made clear that the Fed sees 2% as the desired rate.

Until very recently, though, the problem was that inflation was running too low, not too high. That prompted Powell to say in 2020, when inflation was barely nosing past 1%, to say the Fed would let it rise above 2%.

Many of you may find it counterintuitive that the Fed would want to push up inflation.

But inflation that is persistently too low can pose serious risks in its own right. These risks – namely sparking a deflationary spiral – are why central banks like the Fed would never want to adopt a 0% inflation target.

When the economy shrinks during a recession, causing gross domestic product to fall, aggregate demand for all the things it produces falls as well. As a result, prices no longer rise and may even start to fall – a condition called deflation.

Deflation is the exact opposite of inflation. Instead of prices rising over time, they fall.

At first, it would seem that falling and lower prices are a good thing. Who wouldn’t want to buy the same thing at a lower price?

But deflation can actually prove devastating for the economy. When people feel prices are headed down – not just temporarily, like big sales over the holidays, but for weeks, months or even years – they actually delay purchases in the hopes that they can buy things for less at a later date.

For example, if you are thinking of buying a new car that currently costs $60,000, and we enter a period of deflation, you realize that if you wait another month, you can buy it for $55,000. As a result, you don’t buy the car today.

But after a month, when the car is now for sale at $55,000, the same logic applies. Why buy the car today when you can wait another month and buy it for $50,000?

This lower spending leads to less income for producers, which triggers unemployment. In addition, businesses, too, delay spending because they expect prices to fall further. This negative feedback loop — the deflationary spiral — generates higher unemployment, even lower prices and even less spending.

In short, deflation leads to more deflation. Throughout most of U.S. history, periods of deflation usually go hand-in-hand with economic downturns.

It’s pretty clear then that some inflation is necessary. But how much? Why not 1%, 3% or 4%?

Maybe. There isn’t any strong theoretical or empirical evidence for an inflation target of exactly 2%.

The figure’s origin is a bit murky, but some reports suggest it simply came from a casual remark made by the New Zealand finance minister back in the late 1980s during a TV interview.

Moreover, there’s concern that creating economic targets for economic indicators like inflation corrupts the usefulness of the metric. Charles Goodhart, an economist who worked for the Bank of England, created an eponymous law that states: “When a measure becomes a target, it ceases to be a good measure.”

Since a core mission of the Fed is price stability, the target is beside the point. The main thing is that the Fed guide the economy toward an inflation rate high enough to allow it room to lower interest rates if it needs to stimulate the economy but low enough that it doesn’t seriously erode consumer purchasing power.

Like with so many things, moderation is key.


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