In the early days of last week, Kevin Warsh, the newly appointed chair of the Federal Reserve, testified before two congressional committees and vowed to return inflation to the central bank’s declared goal of 2 percent per year. With inflation, as measured by the personal consumption expenditures (PCE) index, remaining above that target for 63 straight months, Warsh faces a substantial task ahead.
The Fed carries a statutory duty to stabilize prices, alongside its twin aim of maximizing employment. Since 2012, the central bank has chosen to balance these duties by publicly pursuing a steady 2 percent rate of inflation.
Inflation hovered below 2 percent for much of the 2010s, but it surged dramatically in 2021 and 2022 as America emerged from the COVID-19 disruption and both Donald Trump and Joe Biden led large fiscal stimulus efforts. To understand why the Fed remains committed to its 2 percent goal after more than five years of inflation above it, it’s useful to examine the history and the economic reasoning behind the target.
Why set a public inflation target?
The Fed’s price-stabilizing mission formally began in 1977, when Congress enacted the Federal Reserve Reform Act near the end of the Great Inflation, a 17-year period in which annual inflation surged to as high as 14 percent. Paul Volcker, then Fed chair, began aggressively raising interest rates and succeeded in curbing inflation, but those rate hikes produced unforeseen costs—unemployment spiked, and the economy slid into recession. That episode demonstrated that the Fed’s use of monetary policy can shape the course of the economy.
When Alan Greenspan took on the chair’s duties in 1987, he initiated a series of debates at the Federal Open Market Committee (FOMC) about setting an explicit inflation target. Proponents argued that anchoring the public’s expectations would dampen the shocks that occur when the Fed moves interest rates away from a stated goal, reducing the potential for destabilizing aftershocks. As the Fed’s own site explains, “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 contribute to a well-functioning economy and the well-being of all Americans.”
Inflation targeting was first adopted in 1990 by New Zealand, which set a band of 0 to 2 percent for its central bank to keep inflation within. By 1993, Australia, Canada, Finland, Singapore, Sweden, and the United Kingdom had joined in adopting official inflation targets.
By 1996, Greenspan was convinced that a 2 percent target was broadly compatible with price stability. However, he did not want that number to be public knowledge, fearing it might restrict the Fed from acting in the economy’s best interest to avoid explaining deviations from the target. It took until Bernanke’s tenure as Fed chair to enshrine the target as the central bank’s official policy in 2012.
“Greenspan was in favor of maximum flexibility, so if you don’t have a stated target, no one can say you’re missing your target,” David Wessel, the director of The Hutchins Center on Fiscal and Monetary Policy at the Brookings Institution, told The Dispatch. “Bernanke had exactly the opposite argument. This is a way to hold the central bank accountable. It tells … the markets and the politicians, ‘This is what we want to do. And if we’re not meeting our target, you should ask us why not.’”
Why 2 percent?
At a 1996 FOMC meeting, Greenspan defined price stability as “that state in which expected changes in the general price level do not effectively alter business or household decisions.” Pressed by then-Fed governor and future chair Janet Yellen to put a number on that state, Greenspan replied, “I would say the number is zero, if inflation is properly measured.”
Greenspan’s point, as he explained in greater depth a year later, was that most inflation measures fail to properly account for the improved quality and longer life of new products, which ultimately save consumers money. “In theory, economists understand how to value such innovations; in practice, it is an enormous challenge to construct such an estimate with any precision,” Greenspan said in his 1997 speech. Indeed, figuring out what value of inflation by conventional measures best represents a true value of zero is far from straightforward.
The Fed uses the PCE index to monitor inflation, while the consumer price index (CPI) tends to attract more media attention. The CPI reflects the out-of-pocket expenditures of urban households on a representative basket of goods and services. The PCE covers prices for a broader mix of goods and services purchased by consumers or on their behalf, including expenditures by some nonprofit groups serving households and third-party payments like employer-provided health insurance. The CPI tends to run slightly higher than the PCE because of differences in formulas and the PCE’s greater incorporation of substitution when consumers switch to cheaper items. But some economists argue that both measures can overstate real inflation (Warsh has called these gauges “imperfect” and has favored “trimmed” mean inflation gauges that exclude extreme outliers in price changes).
New Zealand, as the first country to implement a public inflation target, had a powerful influence in shaping this approach. Yet even among those deeply involved in crafting the target, the number was not derived from precise science. “It was a bit of a shock to everyone,” recalled Roger Douglas, the country’s former finance minister and a principal architect of the policy, in a 2023 Reuters interview. “I just announced it was gonna be 2 percent, and it sort of stuck.”
New Zealand achieved its goal of bringing inflation below 2 percent within the first two years of the plan. Following that, several other nations followed suit, adopting inflation targets around 2 percent. “The central banks move in herds, and once a few did it, then the U.S. adopted it, everybody kind of adopted it,” Wessel said. “Now it’s kind of accepted, even though there’s no economic model or particular rationale for why 2 versus 1.5 or 3.”
Yet, while 2 percent may not have arisen from a precise formula, it did signify something tangible. Economists concluded that any meaningfully higher target would erode purchasing power too consistently, a reality that has come to define American politics in recent years. Conversely, a markedly lower target would bring the risk of deflation, potentially triggering a negative cycle of reduced spending, higher debt burdens, falling wages, and rising unemployment. Keeping the target above zero also makes it easier for employers to cut real wages during downturns without the political friction of nominal wage reductions.
Given the Fed’s statutory obligation to balance price stability with maximum employment, the 2 percent figure was viewed as a sensible compromise between the two goals.
Is 2 percent still a useful number?
What American central bankers probably did not anticipate was that they would spend much of the decade after the 2008 financial crisis trying to push inflation back up to their 2 percent target. For seven years—from December 2008 to December 2015—interest rates were effectively at zero, leaving the Fed with limited room to spur activity through its rate policy.
Because the federal funds rate is a nominal rate, had the Fed adopted a higher inflation target, it would have implied higher rates in normal times and offered the Fed greater policy leverage over time.
“When the 2 percent target was chosen, no one expected long stretches of near-zero rates,” Wessel said. “It seemed like something that would never happen. So, if you could start over, knowing what we know now, you might pick a somewhat higher target—perhaps 2.5 or 3 percent, or a range like 2 to 3 percent.”
Nevertheless, Wessel and many economists argue that any move away from the 2 percent target at this stage would deal a blow to the Fed’s credibility. In a 2023 piece for the Council on Foreign Relations, former Fed Vice Chair Roger Ferguson argued that even if there was wisdom in raising the target, such a shift could undermine the Fed’s battle to reduce inflation. “One of the Federal Reserve’s main aims is to keep inflation expectations anchored in the public,” Ferguson wrote. “Completely abandoning an inflation target in the middle of a fight against high inflation might do the opposite, thereby raising people’s long-run inflation expectations.”
Although annual inflation has stabilized since its peak in 2022, the prospect of rising prices remains a significant political liability for President Donald Trump. May’s PCE figure climbed to 4.1 percent, partly due to higher oil prices sparked by the Iran conflict. Yet Trump dismissed that increase, saying “the numbers were great.” And while he repeatedly pressured the latest Fed chair, Jerome Powell, to lower rates, reports indicate that he is granting Warsh a grace period as he begins his tenure. With Warsh publicly reaffirming the Fed’s target, the 2 percent goal currently appears secure.
