The Federal Reserve established a 2% inflation target in 2012 as part of its dual mandate to achieve maximum employment and price stability. This target was formalized in the January 2012 Statement on Longer-Run Goals and Monetary Policy Strategy, which specified inflation at 2% as measured by the annual change in the Personal Consumption Expenditures (PCE) price index[1][3].
## Origins of the 2% Target
The 2% inflation target wasn’t arbitrary but emerged after extensive deliberations within the Federal Reserve. Before 2012, the Fed had a de facto 2% target, but it only became official in 2012[3]. The Federal Reserve chose a specific point target of 2% rather than a range for two main reasons:
1. A point target provided clearer guidance, as a range might suggest the Fed was equally satisfied with any value within it, even when variations could be economically significant[1].
2. During the financial crisis when inflation was running below 2%, a point target was considered more effective for supporting expansive monetary policy than a range would have been[1].
## Rationale Behind 2% Inflation
The 2% target represents a careful balance between several economic considerations:
– **Buffer Against Deflation**: The target provides a safety margin against the risk of deflation during economic downturns[4].
– **Price Stability**: It’s low enough to maintain reasonable price stability while allowing some flexibility in the economy.
– **Measurement Bias**: It accounts for potential upward bias in inflation measurements.
It’s worth noting that the 2% target is not strictly empirically derived but represents a pragmatic compromise among various economic considerations[5].
## Evolution of the Target Framework
In recent years, the Fed has moved from a “hard” 2% target to a more flexible approach of “average inflation targeting.” This means the Fed now aims for inflation to average 2% over time, allowing periods above 2% to offset periods below 2%[5]. This framework provides more flexibility while maintaining the same long-term goal.
## Risks of Changing the Target
If the Fed were to raise its inflation target to 2.5%, it would face significant challenges:
1. **Inflation Expectations**: Changing the target during periods of already elevated inflation could unanchor inflation expectations, potentially leading to inflation spiraling out of control.
2. **Long-term Interest Rates**: A higher inflation target would likely push up long-term interest rates, as investors would demand greater compensation for the erosion of purchasing power over time.
The Federal Reserve has indicated that even if it wanted to reconsider its 2% target, it would be unwise to do so during a period of fighting elevated inflation[5]. Any potential reconsideration would likely occur only after inflation has been successfully brought back under control.