Why Does the Fed Target a 2% Inflation Rate?
The Federal Reserve has a dual mandate to maintain maximum employment and price stability in the U.S. economy. And by now everyone knows that the Fed is battling to bring the rate of price growth down to 2%. But how & when did it come up with a target of 2% inflation in the first place?
The answer may surprise you. That figure was articulated in a speech by Ben Bernanke (then the Fed chairman) for the first time in 2012. He posited that a 2% inflation rate was Goldilocks warm–not too hot, but not too cool.
Like cooking pasta. You heat the pot to a boil, add the noodles, then turn down the heat to prevent the water from boiling over the top. The Fed wants the economy to simmer, not overheat.
Why not pursue a target of 0%? For two reasons. First, measuring inflation precisely is difficult, so a 2% reported rate may actually be closer to 1%... or 3%. Second, 2% inflation allows manageable economic growth, but leaves enough room for the Fed to cut rates–and avoid dreaded deflation–if they need to.
Today’s low unemployment rate both helps and hurts the Fed. It helps because the Fed’s first mandate is to maintain maximum employment. But it hurts because more employed workers have more money to spend, and with today’s supply-chain problems, all that spending power drives prices up.
The recent bank failures complicate the Fed’s job because raising rates is intended to reduce liquidity in the economy (and slow inflation), but maintaining/lowering rates is required when the economy needs more liquidity in the face of jitters caused by bank collapses.
It will be interesting to see how arriving at 2% inflation pans out. One thing is sure: now that everyone in the country knows the Fed’s specific goal, it will be well-publicized in news & social media.