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Wednesday, May 10, 2023

Why Does the Federal Reserve Target 2% Inflation?

Ask an Economist #14

Image Credit Wikimedia|CC BY SA 2.5

This week I have a question from Eugene from Missouri about the Federal Reserve. He asks, “we often read that the Fed has a 2 percent inflation ‘target’. Why is that? Why is inflation considered necessary at all? Would it be so bad if the dollar I earn today were still worth a dollar a year from now?”

So, why 2% inflation? Why not 0%? To begin, I’m going to provide some justifications that are typically given for the 2% target. But two important qualifications must be made. First, I don’t agree with all of these justifications. Second, a justification for a policy may be different than the actual cause.

For example, politicians may justify voting for tariffs because they say “it helps national security” all the while the real reason may be that the politicians are receiving donations from these companies, who benefit from the tariffs that hurt their foreign competition.

But let’s begin by asking, why a target?

Why a Target?

The idea of an inflation target is interesting because it implies one thing—consistency. But why have a consistent policy in a world of ever-changing conditions?

First, consistent rates of inflation help people plan better. Over the last two years, Americans have seen what rapidly rising prices can do to plans. Personally, I’ve had to rework my budget several times over the past two years to account for rising food and gas prices.

When you don’t know what prices are going to be, it makes planning difficult. The hours spent planning in an inconsistent world are real hours lost. Other resources used in planning are diminished too. Insofar as consistency helps avoid us using those resources, that’s a plus.

The target also acts as a constraint on the Fed. This has two potential upsides. First, it stops zealous members of the Fed from trying to intervene in the market in reckless ways. Second, it stops politicians from doing so.

So we have some basis for why there would be a target, but why not a constant 0%?

Why 2% Rather than Zero?

Various arguments have been given over the years for why a 2% rate is a good idea.

First, 2% is relatively small. High rates of inflation are harmful because they encourage people to spend significant real resources to stop holding cash. Economists call this concept shoe leather costs. If you’re always running to the bank to pull out your paychecks and get rid of the money as soon as possible, you’re likely wasting real resources to do it.

Second, some argue positive rates of inflation can help employers. How? Well if it’s true that employees won’t accept pay cuts, and economic conditions are such that pay cuts are necessary, the only remaining option for employers is to fire employees. But, if there is a 2% rate of inflation, and an employer gives an employee a 1% raise, this looks like a pay increase but, in terms of real resources, it’s a pay cut.

Economists call this situation where workers won’t accept smaller paychecks a nominal rigidity. If nominal rigidities are a significant issue, a 2% inflation target allows for employers to give real wage cuts without firing.

Finally, consider another good like gold. If there is suddenly a large increase in the demand for gold, what will happen? Well, it will be profitable for businesses to extract more gold and increase the quantity of gold supplied. In markets, the quantity of a good supplied will rise to match increased demand.

Money is also a good. Imagine people increase the demand for having cash on hand (relative to other assets). To match this, there would need to be a larger quantity of money supplied. Increases in the supply of money, all else equal, mean higher prices.

Now technically in our example, the increased demand for money would mean lower prices first, so the increase in supply of money would simply offset that, returning prices to normal. But if the Fed is unable to properly predict and respond to sudden increases in the demand for money, it could instead simply try to increase the amount of money at a higher rate than the typical demand for money. In this case, 2% inflation serves as a kind of rule of thumb where the Fed tries to make sure there is more than enough money to offset increased demand.

But why would it be so bad if money supply did not keep up with money demand? Well, if you (and everyone else in the economy) want to hold more dollars, and no one is creating more, what do you have to do? You have to lower your spending so you can keep more on hand.

When spending is lower business incomes are lower. Ultimately that will mean both inputs (such as labor) and outputs will have lower prices. If businesses correctly anticipate all prices are falling, there is no problem. But if there are nominal rigidities, businesses will have to lay off workers.

What Should Inflation Be?

So the above are the justifications, but I give them a mixed review. I could imagine worse Fed policies, but it isn’t the best of all imaginable worlds.

Ultimately I’m unconvinced by the nominal rigidity argument. It’s easy to sympathize with the idea that workers don’t want a pay cut, but the idea that they would rather be fired and receive zero pay seems even stranger. And this isn’t to mention the fact that this justification amounts to trying to fool workers, which itself seems wrong.

I agree that high rates of inflation are generally harmful (though it’s unclear to me if 2% is really low enough), and I think the general idea of constraints on the Fed is better relative to an alternative of discretion-based policy. On the other hand, I’m somewhat skeptical that constraints like an inflation target can really constrain the Fed in any meaningful way, since the choice of rules is itself discretionary.

So if not a 2% target, what should inflation be? If you think about it, this is a ridiculous question. Imagine asking someone in 2008 how much we should grow the number of iPhones each year. How many oranges should be grown next year? The right answer to these questions is the humble one—I don’t know.

But, even though I can’t give precise numbers myself, I do know of a system that handles these sorts of questions well. On the free market, if entrepreneurs believe they can earn a profit by increasing the supply of a good, they will do so. Successful entrepreneurs will earn profits. Unsuccessful entrepreneurs will bear losses.

At least for now, there is no czar in the US trying to control the exact quantity of most goods produced or the exact rate at which they should change value over time. Money, which is also a good, should be treated similarly. A free banking system, out of the hands of central planners with one-size-fits-all rules or discretion, would be a better approach.

So, what is the best rate of inflation? I don’t know. And neither does the Federal Reserve.


  • Peter Jacobsen is a Writing Fellow at the Foundation for Economic Education.