Two generations of Americans got their first real taste of inflation in 2022, with prices for goods and services surging to a 40-year high in June. After a slow start, the Federal Reserve responded by raising interest rates to cool off the economy and bring inflation back toward its long-term target level of 2%.
But why 2%? Why not zero? If inflation reduces purchasing power by eroding the value of the dollar, why don’t we wish to eliminate it altogether? While the answer is multifaceted, it boils down to providing the central bank with a little maneuvering room during periods of uncertainty.
Inflation is defined as a sustained increase in the general level of prices for goods and services. While the cost of any specific item rises and falls (gasoline, for example), inflation is a broad measure of the overall price level in the aggregate. While there are many metrics designed to measure it, the most familiar is the Consumer Price Index. The index, compiled by the Bureau of Labor Statistics, measures the price level for a basket of around 80,000 common items. Each month, the bureau reports this index as a change in prices over the same month one year ago.
Most consumers alive today have only known stable, modest inflation of around 2% per year, so it came as a rude awakening when the index vaulted to 9% during the supply chain pileup of 2022. Much progress has been made since and today, it stands at 2.9% on a trajectory to reach the target sometime in 2025.
Monetary policy is constantly evolving, and the notion of an explicit inflation target is a relatively recent development born out of the response to the great financial crisis and a fuller understanding of the role that future expectations play in price stability.
Alan Greenspan, who presided over the Federal Reserve from 1987 through 2006, was generally opposed to setting an explicit target. Greenspan believed that Fed policy deliberations should be closely guarded and that hard targets limited the central bank’s flexibility.
Opinion began to shift in the aftermath of the 2006 financial crisis as new research posited that expectations of future inflation were more important to achieving price stability than current levels. For example, the systemic inflation of the late 1970s and early 80s fed on itself and became embedded in the calculus of businesses and households. Everyone expected inflation to continue and acted accordingly.
Greenspan’s successor Ben Bernanke, a student of the Great Depression, advocated for more transparency including release of the Fed’s outlook for the medium term (referred to as forward guidance) to influence long-run expectations.
One important result of this shift to more and better communication included the formal adoption of a stated inflation target in 2012 that was publicized for all the world to see. While Fed members differed on what that target should be, a consensus emerged around a 2% goal, consistent with some other countries.
All of which begs the question: why 2% and not zero?
While not a universal opinion, most economists favor a small but positive rate of inflation to provide some wiggle room given the uncertainty of measurement and the relatively long and variable lags between a policy change (raising interest rates for example) and the actual response of economic output and inflation resulting from that change. This transmission lag is imprecise and can vary from a few months to a couple of years.
First, as previously noted, measurement of inflation is not an exact science. Most experts believe that the Consumer Price Index, as well as the Fed’s preferred alternative metric called the Personal Consumption Expenditure, overestimate true inflation by perhaps 1/2 to 1 percentage point. This suggests that even a 2% index reading could mask a true underlying inflation of 1% or less.
A 2% target also preserves some dry powder to fire at a weakening economy. Interest rate policy is the biggest wrench in the monetary toolbox, but it becomes harder to turn when interest rates fall close to zero, as recent experience demonstrates. While countries in the Eurozone experimented with pushing interest rates below zero between 2014 and 2022 (literally charging depositors for storing their cash), the U.S. has chosen not to breach the zero bound. Evidence suggests that negative rates did not materially improve growth and in fact may have caused more harm than good. A 2% inflation target provides more room to ease during downturns.
Another frequently cited rationale for a positive target is to buy insurance against the antithesis of inflation: deflation, a sustained decline in prices. While the idea of falling grocery prices might sound appealing, many economists believe prolonged deflation is more destabilizing than rising prices. Consumers may delay purchases knowing they may get a better deal next year. And since loans taken out today will be repaid in more valuable dollars in the future, capital investment is impaired. A serious deflationary spiral can inflict more pain than a moderately inflationary one.
There is nothing magical about 2%. Economists believe the target rate should be greater than zero and less than “too high,” and 2% emerged as a compromise. What matters is not the exact target but its existence and the central bank’s ability to steer expectations close to that target over the longer run. On that front, we are nearly back on track.
Christopher A. Hopkins, CFA, is a co-founder of Apogee Wealth Partners in Chattanooga.