Fed's 2% Inflation Target: A History of Balance and Accountability

The Federal Reserve's inflation target of 2% has been a cornerstone of monetary policy for over five years, but its origins and reasoning are not well understood by the public. In mid-July, new Fed Chair Kevin Warsh testified before congressional committees, pledging to restore annual inflation to the central bank's stated target.

The Fed's price-stabilizing role formally began in 1977, when Congress passed the Federal Reserve Reform Act, which came after a 17-year period of high inflation. Paul Volcker, the Fed chair at the time, used aggressive interest rate hikes to curb inflation but triggered unforeseen consequences, including a recession and high unemployment.

When Alan Greenspan became Fed chair in 1987, he commissioned debates about setting an exact inflation target. Proponents argued that it would anchor public expectations even during periods of adjustment away from the target value, limiting aftershocks. As the Fed's website notes, a stable expectation of low and stable inflation allows households and businesses to make sound decisions.

New Zealand was the first nation to implement a public inflation target in 1990, setting a band of 0.5% to 2%. By 1993, several countries had joined it, including Australia, Canada, Finland, Singapore, Sweden, and the United Kingdom. Greenspan considered a 2% target broadly consistent with price stability by 1996 but wanted to keep it private due to potential pressure to meet it.

The Fed officially adopted a 2% inflation target in 2012 under Ben Bernanke's tenure as chair. David Wessel, the director of The Hutchins Center on Fiscal and Monetary Policy at the Brookings Institution, explained that Greenspan preferred flexibility without a stated target, while Bernanke argued for accountability through a public goal.