The Federal Reserve’s stated mandate for monetary operations, as granted by the Federal Reserve Reform Act of 1977, contains maintaining a “price stability” level. Since then, the Fed has tacitly adopted 2% annual inflation as the yardstick for price level. This essay analyzes the history of the Fed’s inflation target setting, gives a critical insight into the pros and cons of that setting, scrutinizes the Fed’s success in achieving its target and makes recommendations for the Fed and Congress.
History of the Fed’s Inflation Target
The Federal Reserve decided on a 2% target for inflation in the 1990s, accompanied by several monetary policy reforms. Getting ready to raise rates, the Fed and central banks, in general, were now talking about keeping monetary policy tight to achieve the desired economic consequences (Board of Governors Federal Reserve System). However, the lessons from the 1970s and 1980s, when the inflation rate and economic uncertainties were very high, encouraged the policymakers to re-evaluate their policy (Roger). Central banks have finally begun to understand that price stability is the key to overall economic growth, precisely the persistent type. Moderate inflation, around 2% annually, was deemed desirable since it created a small margin for all sorts of risks without the negative impacts of too high inflation. This era has been marked by deflation targeting as a common monetary policy tactic adopted by most central banks around the globe.
In 2012, the Fed’s critical monetary policy-making body, the FOMC, officially named a 2% inflation rate as a goal. This resolution was based on a decisive strategy aimed at giving the public and the financial markets a clear idea of the Fed’s policy intentions regarding interest rates and the overall economy. The Fed explicitly targets annual inflation at 2%, which helps to curb inflationary expectations. This ensures that the economic environment has lower fluctuations, making it easier for long-term planning. The 2% inflation target, which was in line with the Fed’s overall mandate to support maximum employment and price stability, also took place by the beginning of 2012 (Balfour). The Fed expected to achieve its dual mandate more effectively by setting a target for inflation. Rather than defining the “target” as a rigid rule, the flexible benchmark would enable the Fed to accommodate various economic conditions by adjusting its policy stance.
Pros and Cons of the Fed’s Inflation Target
The Federal Reserve Bank’s inflation targets are multifaceted, so they remain popular and widely used. The key advantages of the monetary policy framework include the following: it outlines the path for policymakers and is transparent and straightforward (Jacobsen). The opening up of a specific door, such as inflation, currently stands at the 2% level of the Fed, enabling it to communicate its policy goals to the public and financial markets. This transparency minimizes the chances of instability in the investment and borrowing outlooks and keeps them anchored. It needs to be more manageable and demonstrates the need of businesses and consumers to make timely decisions on spending and investment.
One of the benefits of the inflation objective is that it helps the Fed to balance the trade-off between volatility and unemployment, which are the principal objectives of the Fed. This is as per the dual mandate of the Fed. The Fed can strive for the middle point of inflation and, hence, help to maintain price stability with the same target of maximum employment. This approach is applicable as it assumes that a moderate level of inflation can boost the economy by creating a constant environment that helps investors and consumers invest and consume. On the other hand, doubters of the flat target rate issued by the Fed assert that it is an arbitrary measure and may not work in all economic conditions. Some economists argue that the inflation target should be ramped up to 4% or more during those periods when there is low demand (Board of Governors Federal Reserve System). With a higher inflation target, the Fed would have more space for reducing interest rates so the economy would not fall into recession, which could boost investment and health the recovery of the business cycle.
In contrast, different economists suggest having an inflation target of less than 0% or even harmful (Quiggin). This idea is expressed as the opponents assert that a lower inflation target would disallow wear-out of purchasers’ currency, and therefore, investors and savers are the primary beneficiaries (Jacobsen). On the other hand, a target that is too low can also bring a risk of deflation, falling prices related to a stagnant economy, and economic weakness.
Evaluation of the Fed’s Performance
Comprehending the Federal Reserve’s becoming decisive in preserving the 2% inflation target imperatively requires acquaintance with the broader economic framework. Informal and formal adoptions of such targets make inflation stay around the adequate or accepted level, meaning that countries more and more orient their economic policies towards price stability (Edwin). Yet this is an accomplishment because, usually, the stability of prices has a significant financial impact in that it affords consumer and business confidence, long-term planning and shelter against the unwelcome results of either high inflation or deflation. Yet, the Fed has many challenges, especially after the global economic crisis 2008 (Karabell). Despite introducing a beat of substantial and unprecedented monetary stimuli, inflation usually settles below the 2% ceiling (Edwin). Such a long-term ‘low inflation’ has made people wonder if this is proof of the way the monetary policy of the FED is implemented and how the FED can meet the dual mandate of full employment and price stability.
One reason why the Fed has lacked the prowess to attain its inflation objective might be the lagging in worker wage growth (Jacobsen). Real progress has yet to be made in the labour market while wage growth is still lagging, implying modest inflation expectations and challenging sustaining price pressures (Messeri). On the contrary, other structural factors like globalization and modern technology have also negatively affected the cost of living. Hence, a central bank like the Federal Reserve FOMC finds it challenging to generate the right amount and maintain inflation. In addition to these hurdles, there have been additional difficulties the Fed had to face in the form of the low effects of its monetary policy instruments on inflation expectations (Robert Aero). The Fed used unconventional remedies, like quantitative easing, to boost inflation to some extent. Still, at the same time, those measures didn’t elicit a corresponding increase in inflation expectations from businesses and consumers (Jeff Sommer). The central issue is that the Fed’s policies lost connection with the market participants and corporate price expectations about inflation. Therefore, keeping the CPI levels at the predetermined target took a lot of work for the Fed.
Recommendations for the Fed and the Congress
The two parties could adopt the following steps to make the monetary policy more effective (Edwin). An example is revising the 2% inflation target and considering how the changing economic structure would benefit from a new target (Nerkar). Furthermore, the Fed could consider other policy tools, such as nominal GDP targeting, which come in handy for the dual mandate objectives.
In conclusion, the target inflation rate set by the Federal Reserve has been an essential component of the Fed’s monetary policy framework, making its aim at price stability more straightforward and more transparent. However, it is widely recognized that the policy exceeds its purpose of maintaining price stability and keeping the economy stable rather than not. There are critical debates and contested views on whether the target is still effective and appropriate considering the economic changes. For the sake of improvement in the efficiency of monetary policy, policymakers must think over the idea of multiple evaluations and refinements of inflation targets, moreover considering new ways and future hindering issues. By evaluating what works and what does not in the current scheme and correcting important maladjustments, policymakers would enhance operational flexibility, which would favour achieving the objectives of maximum employment and price stability by the Fed.
Works Cited
Board of Governors Federal Reserve System, “Why Does The Federal Reserve Aim for Inflation of 2 Percent Over the Long-Run?
Brian Balfour, “Inflation is a Tax That Nobody Voted For” John Locke Foundation (May 24, 2022)
Edwin Vieira, Jr., “What is a Dollar?” Foundation for Economic Education (November 1, 1994)
Ethan Messeri, “Why the 2% Inflation Target?” Michigan Journal of Economics (September 4, 2023)
Frank Shostak, “Falling Prices are a Good Thing,” Austrian Economics Center (April 3, 2018)
Jeff Sommer, “The Fed Has Targeted 2% Inflation. Should It Aim Higher?” The New York Times (March 24, 2023)
John Quiggin, “Inflation Target Tyranny” (January 27, 2012)
Peter Jacobsen, “Why Does the Federal Reserve Target 2% Inflation?” Foundation for Economic Education (May 10, 2023)
Robert Aro, “The Origins of the 2 Percent Inflation Target” Mises Institute (September 16, 2020)
Roger W. Ferguson and Upamanyu Lahiri, “The History and Future of the Federal Reserve’s 2 Percent Target Rate of Inflation”, Council on Foreign Relations (June 15, 2023)
Santul Nerkar, “The Fed’s Inflation Goal is Completely Arbitrary” FiveThirtyEight (March 9, 2023)
Zachary Karabell, “The Fed’s 2% Inflation Target Is a Made-Up Number”, Time Magazine (December 19, 2023)
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