What’s so special about the Fed’s 2% inflation target?

What’s so special about the Fed’s 2% inflation target?

What’s so special about the Fed’s 2% inflation target?

Stocks took a hit Thursday, pretty much across the board. The nosedive stemmed, in part, from fears that the Federal Reserve will keep interest rates higher in 2023 than investors would like, risking a recession and potentially pulverizing corporate profits.

“We expect,” Fed Chairman Jay Powell said during his news briefing on Wednesday, “that the ongoing hikes in the target range for the federal funds rate will be appropriate in order to achieve a tight enough monetary policy stance to bring inflation to 2% over time.”

In other words, we will keep rates high until we see annual inflation fall towards 2%, the Fed’s long-standing target.

But why is 2% the magic number?

Economists mostly agree that double-digit inflation is bad and deflation is a symptom of a failing economy. But 2% specifically? That number doesn’t come from an elaborate equation that Milton Friedman or Alan Greenspan came up with. It’s not even from the US

“So since 1990, New Zealand became the first country to gamble on inflation,” said Julie Smith, an economist at Lafayette College.

New Zealand’s central bank basically said, “Let’s go for about 2%.” And then the New Zealand economy has done very well.

So central banks around the world figured they’d try the same thing. But correlation is not causation.

“The evidence in the empirical literature is somewhat mixed as to whether or not having an inflation target of 2% actually leads to economic growth,” Smith said.

The Fed announced it was officially aiming for 2% in 2012, under chairmanship of Ben Bernanke. Rolling back that number now would send exactly the wrong message at exactly the wrong time, according to former Fed economist Ann Owen.

“If they keep changing their targets, it’s very difficult for people to form consistent inflation expectations,” he said.

If Jay Powell came out and said, “You know what, we’re good at 4%,” people would think he’s losing the inflation battle, which would only fuel more inflation.

But there’s an obvious tradeoff to getting to 2%, economist Skanda Amarnath said with Employ America: “They’re willing to risk far greater job losses. We’re talking about millions of people here.”

Remember, the Fed has a dual mandate: to keep inflation in check and full employment. And those mandates are in conflict.

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