Fed Sticks with 2% Inflation Target Amid Rising Economic Pressures

The Federal Reserve has committed to keeping annual inflation at 2%, but with inflation running above this target for over five years, there's a lot of work ahead for new Fed Chair Kevin Warsh. In mid-July, Warsh testified before congressional committees and pledged to restore the economy to its stated goal.

The Fed's price-stabilizing role began in 1977, when Congress passed the Federal Reserve Reform Act near the end of the Great Inflation period. At the time, inflation rates spiked as high as 14%. Paul Volcker, then-Fed chair, aggressively raised interest rates to curb inflation but triggered unforeseen consequences: unemployment spiked and the economy plunged into a recession.

When Alan Greenspan took over in 1987, he commissioned debates about setting an exact inflation target. Proponents argued it would anchor public expectations even when adjusting interest rates away from the target value, limiting aftershocks. As the Fed's website puts it, 'When households and businesses can reasonably expect inflation to remain low and stable, they are able to make sound decisions regarding saving, borrowing, and investment.'

New Zealand was the first nation to implement a public inflation target in 1990, setting a band of 0.5-2% for its central bank. Other countries like Australia, Canada, Finland, Singapore, Sweden, and the UK soon followed suit. By 1996, Greenspan believed a 2% target was broadly consistent with price stability.

However, even experts acknowledge that 2% is not the result of exact science but rather a compromise between keeping inflation from eroding purchasing power and avoiding deflation's risks. Employers can more easily reduce real wages during economic downturns without nominal wage cuts under a higher target like 2%. The Fed uses the PCE index to track inflation, which tends to slightly outrun the consumer price index.

David Wessel from The Hutchins Center on Fiscal and Monetary Policy at Brookings Institution notes that central banks often move in herds once a few countries adopt an inflation target. The 2% number has become accepted despite there being no economic model or particular rationale for why it's the optimal choice.