Why 2%
Perhaps surprisingly given its current ubiquitousness, 2% inflation has not always been a goal that defined U.S. monetary policy. Spanning the U.S. Federal Reserve’s 100+ year history, it’s a relatively recent ambition.
While the crux of this post is to highlight the formation of the Fed’s current inflation target, it’s important to discuss the overall history of the U.S. central bank—how, and why the Fed became a pivotal force in steering the U.S. economy.
History of The Fed & FOMC
The Federal Reserve System was created in 1913 through the passage of the Federal Reserve Act. The Fed was established largely in response to a series of financial panics in the late 1800s and early 1900s (notably the financial panic of 1907) that steered the country towards wanting a more centralized monetary policy (while seeking to balance it with a decentralized banking ecosystem). There are three key entities within the Fed: 1) the Board of Governors, 2) the Federal Reserve Banks, and 3) the Federal Open Market Committee (FOMC). Together, they seek to promote a well-functioning U.S. economy and financial system.
In general, The Fed performs five functions[i]:
Administers the nation’s monetary policy to promote maximum employment, stable prices, and moderate long-term interest rates [more on this later];
Promote the stability of the financial system and seek to minimize and contain systemic risks through active monitoring and engagement in the U.S. and abroad;
Promote the safety and soundness of individual financial institutions and monitors their impact on the financial system as a whole;
Foster payment and settlement system safety and efficiency through services to the banking industry and the U.S. government that facilitate U.S.-dollar transactions and payments; and
Promote consumer protection and community development through consumer-focused supervision and examination, research and analysis of emerging consumer issues and trends, community economic development activities, and the administration of consumer laws and regulations.
During the 1920s, the Fed began using “open market operations” (buying/selling large quantities of government securities in the public markets) as a monetary policy tool. But it was the passage of the Banking Act of 1935, that the Federal Open Market Committee (FOMC) was formally established to set U.S. monetary policy.
The FOMC oversees the size and composition of the Fed’s balance sheet which enables it to set market interest rates in line with its target federal funds rate. The fed funds rate (the rate at which banks are willing to lend to each other) is what most of us know today as the “target rate.” By raising (lowering) its target rate, the FOMC seeks to lower (stimulate) inflation; stable rising prices are typically associated with a growing economy. Importantly, as we see any time a Fed official speaks, the FOMC is also responsible for communication with the public about the current and future path of monetary policy.
While the basics of the Fed’s operations have stayed mostly the same since inception, the way the FOMC conducts monetary policy has changed over the years, notably with the setting of its current “dual mandate.”
The Dual Mandate
In 1977, in response to years of high unemployment and high inflation, Congress explicitly directed the Fed to "promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates." Though that sounds like three objectives, this is what we know as the Fed’s “dual mandate” of seeking maximum employment and stable prices.[ii] While the maximum level of employment does not have an objective meaning or fixed number,[iii] price stability has been defined, implicitly or explicitly, by an inflation target.
2% (Inflation) is Better for You?
“The Federal Open Market Committee (FOMC) judges that inflation of 2% over the longer run, as measured by the annual change in the price index for personal consumption expenditures, is most consistent with the Federal Reserve’s mandate for maximum employment and price stability. 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, which contributes to a well-functioning economy.”
The U.S Fed has pinpointed 1996 as when it was implicitly understood that 2% was their inflation target.[iv] However, the 2% target did not explicitly exist until it was set by the Ben Bernanke-led Fed…in 2012! Looking back further—and perhaps highlighting the importance of credible communication with the public—the first time a 2% inflation target was announced by any central bank was in 1989…in New Zealand.[v]
In 2012, many academic-minded individuals, including the aforementioned Ben Bernanke, as well as then Fed Vice Chair Janet Yellen (who’d later become Fed Chair and is currently the U.S. Secretary of the Treasury) were concerned about deflation (falling prices), and not inflation. Thus, while some were seeking a 0-1% inflation target, a 2% target was deemed more favorable, as it would (at least hypothetically) provide the Fed more wiggle room to cut its target rate and stimulate the economy. Given these still low targets, this past decade has even seen negative interest rates implemented.
To make matters even more complex, in 2020 current Fed Chair Jerome Powell steered the FOMC from a static 2% target to a 2% long-run average goal.
“We will seek to achieve inflation that averages 2 percent over time. Therefore, following periods when inflation has been running below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.”
- Fed Chair Jerome Powell (August 2020)
So, for those wondering why there has been talk about lowering the target rate even though inflation has not fallen to 2%, it’s because average inflation targeting enables the Fed to be comfortable with higher inflation (at least in the short-term) if the prior period experienced sub-2% inflation.
Why Not 3% Inflation (on average)?
So, if the 2% inflation target seems arbitrary, perhaps it is. Which begs the question, could the Fed decide to raise its target? Certainly, that’d be cheered by many on Wall Street who think rates are too high and creating an unnecessary economic headwind (never mind the U.S. economy seems to be doing just fine). Yet, the burden of higher “acceptable” inflation would certainly be admonished by those concerned about the impact on Main Street, particularly those monitoring the affordability crisis in the housing market.
With most inflation measures now showing aggregate consumer and wholesale prices back below +4% year-over-year, the Fed certainly would be more open to slashing the fed funds rate if target inflation was 3%; ditto if they moved back to maintaining “price stability” with no explicit target. But as we saw with setting the explicit target in 2012—when there was fear the Fed wouldn’t be able to stimulate the economy enough—recent (post-pandemic) memory of spiking prices has likely led many in the upper echelons of monetary policy to fear the opposite…that the Fed could risk stimulating the economy too much.
At SineCera Capital, we’ve been saying for the past several months that the Fed (FOMC) won’t substantially cut rates because it wants to, but because it has to (e.g., when the economy inevitably falls into a recession, or if there’s some other extemporaneous market shock). So, while many may seek to express their expertise by projecting the trajectory of interest rates, we prefer to position our clients’ portfolios in advance. Even though inflation targeting is relatively new, the likely factors that would lead the FOMC to change course are as unpredictable as they have always been.
Best Regards,
Adam J. Packer, CFA®, CAIA®
Chief Investment Officer | SineCera Capital
[i] https://www.federalreserve.gov/aboutthefed.htm
[ii] https://www.federalreserve.gov/monetarypolicy/monetary-policy-what-are-its-goals-how-does-it-work.htm#
[iii] https://www.federalreserve.gov/monetarypolicy/files/fomc_longerrungoals.pdf
[iv] https://fredblog.stlouisfed.org/2020/11/from-inflation-targeting-to-average-inflation-targeting/
[v] https://sites.lsa.umich.edu/mje/2023/09/04/why-the-2-inflation-target