Why is the Fed’s Target 2% Inflation?

by | Nov 10, 2023 | Research

Federal Reserve Chairman Jerome Powell has spent the last two years confirming that the Fed is committed to bringing inflation down to their 2% target. This goal may come as a surprise given that Chair Powell has also said that inflation “imposes significant hardship as it erodes purchasing power, especially for those least able to meet the higher costs of essentials.”

With these seemingly contradictory statements, you may be wondering – if inflation harms the most vulnerable Americans, then why does the Fed seek to promote a positive inflation rate? Further, why is the target 2%, specifically?

What happens if inflation is above 2%?

When inflation is above the Fed’s 2% target, economists often say it is “overheating” or “too hot.” This situation typically occurs when demand is higher than supply and it often leads to adverse outcomes for the average American.

Lower Purchasing Power and Savings Rates

The most obvious result of high inflation is that income no longer buys the same amount of goods and services. Some people, especially those with low incomes, are unable to buy the basic things they need – like food, shelter, and medical care – which can have a disastrous impact on their quality of life. Even consumers with moderate or high incomes can be forced to cut back when inflation is high.

Since people need to spend more of their income on necessities, they also have less money to save during a period of high inflation. Lower savings means these people can be under prepared for a personal emergency or economic downturn in the future.

On a larger scale, low savings rates can increase the risk of loan defaults, reduce bank deposit levels, and even keep money from flowing into investment markets. These factors generally lead to a weakening economy – resulting in less economic freedom for the average American.

Devalued Currency

High inflation in one country tends to make their currency less valuable compared to other countries that are not experiencing the same rate of inflation. This devaluation of currency makes exports more appealing to other countries and imports more costly in the country that is experiencing high inflation.

Runaway Inflation

Without intervention from the Fed, inflation often spirals – meaning that inflation leads to more inflation. One reason for this phenomenon is higher input costs can lead to higher costs for finished products.

To illustrate, consider this simplified example. Energy prices rise and many companies raise the price of their finished products to compensate. Workers cannot buy the same amount of goods at the new prices, so they demand higher wages. These higher wages erode profit margins, so businesses raise their prices and the cycle restarts.

If left unchecked, a cycle of rising prices can leave Americans grappling with inflation for years or even decades. This cycle can even lead to stagflation – a situation where inflation continues to climb despite a weakened economy.

Higher Interest Rates

Due to the many negative ramifications of high inflation, the Fed often steps in when inflation is too hot. This intervention typically comes in the form of higher interest rates which make large purchases more expensive for consumers and businesses. These higher borrowing costs reduce demand, which helps bring supply and demand back into balance and, consequently, reduce inflation.

The Fed’s interest rate policy is often described as a “blunt tool” because it can be an unwieldy weapon in the fight against inflation. Higher interest rates can help lower inflation but there is often collateral damage to the economy and employment.

Overall, high inflation is usually a symptom of a larger problem – like an overheating economy or a massive drop in supply. The rapidly increasing prices that result from this problem can be disastrous for individuals and businesses. For this reason, the Fed works hard to keep inflation from becoming “too hot.”

What happens if inflation is below 2%?

Inflation that is below the Fed’s 2% target may seem like a good thing. After all, stable – or even falling – prices help people afford the goods and services they need. However, inflation that is “too cold” is often a symptom of larger issues that negatively impact the economy and individuals.

High Unemployment

Inflation that is very low or even negative – known as deflation – tends to occur when supply exceeds demand. Businesses may cut production in this scenario since they often strive to produce goods and services to match the level of demand. When businesses produce fewer goods and services, they need less labor which can lead to a high unemployment rate.

Slow Economic Growth and A Weaker Stock Market

The factors that tend to create low inflation – such as supply exceeding demand – tend to occur when the economy is slowing. This situation often leads to lower business sales and, consequently, lower stock prices.

Very Low Fed Funds Rate

When inflation and economic growth are slow, the Fed tends to lower interest rates to help spur demand. However, if the Fed leaves interest rates low for an extended period, there is no room to reduce them in the event of economic turmoil.

For example, the Fed Funds Rate was low by historical standards leading into the COVID-19 pandemic. This left the Fed little room to reduce interest rates during the brief recession in 2020.

Individuals often view very low inflation positively because it keeps prices predictable for the goods and services they need. However, the economic situation that leads to very low inflation can cause its own kind of pain.

What happens if inflation is exactly 2%?

The Fed’s target of 2% inflation is the “Goldilocks Scenario” – meaning that it is neither “too hot” nor “too cold.” This ideal scenario often occurs when the economy is growing at a moderate pace. Inflation at the 2% target – and the economic conditions that typically accompany it – can lead to a stable currency, strong labor market, and moderate interest rates.

Stable Currency

Many of the world’s largest economies – including Australia, the Euro Area, and Japan – also have a 2% inflation target. Therefore, currencies are not negatively impacted by changes in inflation when each country achieves their target.

Stable currencies can help keep imports and exports steady within an economy. They also allow people to continue buying the same amount of goods and services from foreign companies.

Growing Economy and Stock Market

Inflation at exactly 2% often occurs when the economy is growing moderately, and demand modestly outpaces supply. This situation encourages businesses to expand to meet growing consumer needs. When companies expand, their revenue tends to grow. This higher revenue promotes healthy profits and a strong stock market.

Strong Labor Market

In addition to a strong stock market, an economy that is growing at a moderate pace also tends to promote a healthy labor market. This includes enough available jobs to keep the unemployment rate low and provide workers with the leverage to negotiate better working conditions. It also means that jobs aren’t so plentiful that businesses struggle to fill open positions.

A Moderate Fed Funds Rate

When inflation is at or near the Fed’s target, employment is strong, and the economy is growing at a sustainable pace, the Fed can leave interest rates at a moderate level. This leaves room to raise or lower interest rates to meet the changing needs of the economy.

The “Goldilocks’ Scenario” of 2% annual inflation helps the Fed accomplish their mandate of stable prices and maximum employment for the American people. It also gives them room to maneuver if the economy changes.

While the 2% inflation scenario is often “just right,” for the economy, it can be difficult for the Fed to achieve. This difficulty often results in economic stress when the Fed is aiming to increase or decrease inflation. Your finances – including your investments – can be impacted by this economic stress. Fortunately, an experienced wealth manager can guide you through changes in the economy and investment markets so that you can make the most of the situation.

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Article Topics: Interest Rates