Earlier this month, the Federal Open Market Committee (FOMC) voted to raise the Fed Funds rate by 0.25% to a target of 5.0% to 5.25%, a 16-year high. This is the 10th straight rate hike on the path to their goal of pushing inflation back down to a target of 2%. Two percent sounds great compared to the 9% high in 2022 or even the current 5%, but why is 2% the goal?
When I envision how the Fed reached a 2% inflation target, I imagine economists doing complicated calculations at a chalk board, like scenes from the movie Hidden Figures when scientists are working out the math to get to the moon. The real story of 2% isn’t quite as sophisticated.
In the late 1980’s, New Zealand was struggling with double digit inflation. Arthur Grimes, New Zealand’s Central Bank chief economist at the time, began traveling to other countries to learn how they tackled inflation. Some had a monetary supply target, capping how much money is printed each year. Others had an employment target and some, interest rate target for loans. Armed with this knowledge, Grimes decided that New Zealand would be better off targeting their issue head on by attacking inflation directly. The slogan, “Zero to two by ’92,” was created with the objective of reaching their inflation target by 1992.
Under Grimes’ leadership, the Reserve Bank of New Zealand Act of 1989 introduced inflation targeting to the world, as a technique to anchor inflation expectations and promote price stability. Prior to this, no central bank had created a plan to specifically target inflation.
New Zealand’s new inflation reduction policy took off, and over time other central banks moved to adopt this mindset including Canada, the United Kingdom and Sweden. Following its establishment in 1998, the European Central Bank adopted a 2% target inflation rate. Like Rihanna at the Met Gala, the US was late to the party, not declaring a 2% target until 2012 (though it was likely practiced sooner than that). The 2% target wasn’t based on empirical evidence, but if you say 2% enough and much of the developed world gets on board, it becomes a self-fulfilling prophecy. As my college chemistry professor would say, “It’s close enough for government work.”
Is 2% the right target? Many argue that 3-4% would be a better target because it likely wouldn’t impact the economy substantially compared to 2% but would provide additional room to drive interest rates lower in future tough economic periods. Currently, the FOMC states that they believe 2% is most consistent with the Federal Reserve’s mandate for maximum employment and price stability.
Regardless of how we arrived at a 2% inflation target, I suspect we’re all looking forward to the days when buying eggs and filling up our gas tanks doesn’t raise our blood pressure and thus, are cheering on the FOMC to reach their goal. Until then, in the words of Kathleen Norris, “In spite of the cost of living, it’s still popular.”