The Fed wants to bring inflation down to 2%. But why not 3%? Or 5%?
The Fed wants to bring inflation down to 2%. But why not 3%? Or 5%?
Stocks took a beating 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 anticipate,” Fed Chair Jay Powell said during his news conference Wednesday, “that ongoing increases in the target range for the federal funds rate will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2% over time.”
In other words, we’re keeping rates high until we see annual inflation headed down toward 2%, the Fed’s longstanding target.
But why is 2% the magic number?
Economists mostly agree that double-digit inflation is bad, and deflation is a symptom of a crashing economy. But 2% specifically? That number doesn’t come from some elaborate equation Milton Friedman or Alan Greenspan came up with. It doesn’t even come from the U.S.
“So, starting in 1990, New Zealand moved to becoming the first inflation-targeting country,” said Julie Smith, an economist at Lafayette College.
New Zealand’s central bank basically said, “Let’s go for around 2%.” And then the New Zealand economy did really well.
So central banks around the world thought about trying the same thing. But correlation is not causation.
“The evidence in the empirical literature is somewhat mixed on whether or not having a 2% inflation target will actually lead to economic growth,” Smith said.
The Fed announced it was officially targeting 2% in 2012, under Chair Ben Bernanke. Backing off that number now would send exactly the wrong message at exactly the wrong time, according to former Fed economist Ann Owen, now a professor at Hamilton College.
“If they keep changing their goals, it’s very difficult for people to form consistent inflation expectations,” she said.
If Jay Powell came out and said, ‘You know what, we’re good with 4%,” people would think he was losing the inflation fight — which would only fuel more inflation.
But there’s an obvious trade-off to get to 2%, said economist Skanda Amarnath with Employ America: “They’re willing to risk much larger job losses. We’re talking about millions of people here.”
Remember, the Fed has a dual mandate — keeping inflation in check and full employment. And those mandates are in conflict.
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