History and Evolution of the Fed’s Inflation Target

A man hitting a target with a dart to symbolize the Fed seeking to achieve their inflation target.

Understanding the Fed’s actions is vital to many businesses – especially those whose revenues are significantly affected by prevailing interest rates. The Fed maintains the balance between unemployment and inflation using several tools, but the most important of these is management of the Fed Funds Rate.

In recent history, the long-run target for the Fed Funds Rate has been 2%. This is the rate the committee sees as the equilibrium point, but what led them to this conclusion? Further, how has this target rate changed over the years, and where can we expect it to go in the future?

1977: Price Stability Becomes Part of the Fed’s Mandate

The Fed has focused on price stability for much of its history, but it wasn’t until 1977 that they had a Congressional mandate to do so. In that year, Congress passed the Federal Reserve Reform Act of 1977 which sought to establish objectives for the Fed as well as improved accountability to Congress.

The legislation followed a decade of high inflation, so it is no surprise that price stability was one of the established goals. What may surprise you, however, is that there was no explicit target for what was considered an acceptable level of inflation at that time. In fact, a target would not be established for nearly two decades.

1996: The Fed Sets an Implicit Inflation Target

At the first FOMC meeting of 1995, committee members began to discuss the merits of an official inflation target. Proponents of a specific target argued that it would enhance the credibility of the Fed, help anchor inflation expectations, and possibly even lower the cost of achieving price stability.

On the other side of the debate, committee members argued that a target inflation rate would place undue constraints on the Fed. Their fear was that an official target rate could prevent the committee from taking necessary action during cyclical economic downturns.

This debate continued throughout the following year, and the FOMC appeared to reach a consensus on a target rate in 1996. However, Alan Greenspan was chair of the FOMC, and he did not publicize the target rate.

Don Kohn, director of the monetary affairs division during this time, explained that Greenspan did not want to publicize the inflation target to preserve the Fed’s discretion. In other words, Greenspan wanted the Fed to be able to take the necessary actions to achieve their goals without the need to answer public questions regarding the target.

2000s: Continued Research and Debates Surrounding an Inflation Target

The FOMC continued to debate the merits of a public inflation target for over a decade. Among the proponents of a public target was economist Marvin Goodfriend.

In 2004, Goodfriend published an essay titled Inflation Targeting in the United States. The document argued that “in a democracy, a central bank should be fully accountable for the monetary policy that it pursues.”

Goodfriend and other supporters felt that a public target would enhance transparency and accountability for the Fed. They further believed that better communication and explicit goals would improve the Fed’s image and outcomes.

Following Greenspan, the Fed was chaired by Ben Bernanke – a supporter of an explicit target rate. He brought the debate to the FOMC once again in 2006, and during the debate, committee members struggled to reach consensus. They were at odds on whether an inflation target was needed, and if so, what it should be.

2012: The Fed Announced an Explicit Inflation Target

The discussion was effectively tabled during the Great Recession when economic turmoil, bank failures, and general financial instability took center stage. Once the crisis passed, the FOMC returned to the topic of an inflation target.

At the November 2011 FOMC meeting, 11 of the 14 committee members spoke in favor of an explicit inflation target, so Chair Bernanke asked San Fransisco Fed President Janet Yellen to develop a statement of principles. This document would explain the inflation target and how it fit within the Fed’s dual mandate of maximum employment and stable prices.

Finally, in January 2012, the Committee released the Statement on Longer-Run Goals and Monetary Policy Strategy which officially announced the 2% target. The statement explained the benefits of such a target:

“Communicating this inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored, thereby fostering price stability and moderate long-term interest rates and enhancing the Committee’s ability to promote maximum employment in the face of significant economic disturbances.”

2020: The Fed Updated the Policy Statement to Reflect an Average of 2% Inflation

Amid the COVID-19 pandemic in August 2020, the FOMC released an update to the Statement on Longer-Run Goals and Monetary Policy Strategy. The language in the document was softened to “the Committee seeks to achieve inflation that averages 2 percent over time.”

Prior to the change, the inflation rate had been running below 2% for several years. The change allowed the Fed to aim for an inflation rate above the stated target for a period of time so that the average would be 2%.

In a Q&A following the change, the FOMC explained, “[b]y seeking inflation that averages 2 percent over time this will help ensure longer-run inflation expectations do not drift down and remain well anchored at 2 percent.”

2024 and The Future of the Inflation Target Rate

Following the 2020 change, the Fed allowed inflation to run above the 2% target. Since that time, inflation has remained well above 2%, and now they are facing the difficult task of bringing it back down.

However, a key question remains: when the 2% target is met, will the Fed attempt to push inflation lower than 2% to achieve their average target? If so, how far will they go and for how long? Only time will tell.

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