Why does the Federal Reserve aim for inflation of 2 percent over the longer run? (2024)

FAQs

Why does the Federal Reserve aim for inflation of 2 percent over the longer run? ›

The Federal Open Market Committee (FOMC) judges that inflation of 2 percent over the longer run, as measured by the annual change in the price index for personal consumption expenditures, is most consistent with the Federal Reserve's mandate for maximum employment and price stability.

For example, contracts assumed a 2% inflation rate, which means wages would only rise 2% a year. This meant that costs only would have to rise 2%, meaning that inflation slowed.

Tags. Annual CPI inflation was unchanged at 2.0 per cent in June 2024. This was driven by the low monthly figure from June 2023 of 0.13 per cent dropping out and the new inflation for June 2024 coming in at 0.11 per cent on the month, yielding no change in the headline figure after rounding.

And the stronger demand for goods and services may push wages and other costs higher, influencing inflation. During economic downturns, the Fed may lower the federal funds rate to near zero. In such times, the Fed can use other tools to influence financial conditions in support of its goals.

The Committee reaffirms its judgment that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate.

The rigidness of the 2% target that held for so long is no longer applicable in an era of profound change in the labor market, the global supply chain and constrained supplies of energy, food and housing. For this reason, we suggest that a more flexible target of 2.5% to 3.0% is a better fit.

This is a rate of inflation sufficiently low that it does not materially distort economic decisions in the community. Seeking to achieve this rate, on average, provides discipline for monetary policy decision-making, and serves as an anchor for private-sector inflation expectations.

What does a 2 percent annual inflation rate mean? On average, a dollar buys 2 percent fewer goods and services than it did the year before.

Officials at the Federal Reserve are expecting inflation to keep easing over the next two years and have penciled in a return to their 2% target in 2026.

What is the ideal inflation rate? ›

One of the mandates of the Federal Reserve System is to promote stable prices in the United States. To achieve price stability, the Federal Reserve targets a long-run inflation rate of 2 percent.

This, then, became the era of “stagflation.” In 1964, when this story began, inflation was 1 percent and unemployment was 5 percent. Ten years later, inflation would be over 12 percent and unemployment was above 7 percent. By the summer of 1980, inflation was near 14.5 percent, and unemployment was over 7.5 percent.

Reasons for our inflation target of 2%

Providing a safety margin against the risk of deflation and making sure monetary policy remains effective when it needs to respond to inflation that is too low. Having a margin against deflation is important because there are limits to how far interest rates can be cut.

Inflation occurs when there is a general increase in the price of goods and services and a fall in purchasing power. This can benefit borrowers in that it allows them to repay debts with money that has depreciated in worth. However, it can also benefit lenders in that it raises prices and increases demand for credit.

More jobs and higher wages increase household incomes and lead to a rise in consumer spending, further increasing aggregate demand and the scope for firms to increase the prices of their goods and services. When this happens across a large number of businesses and sectors, this leads to an increase in inflation.

To keep inflation low and stable, the Government sets us an inflation target of 2%. This helps everyone plan for the future. If inflation is too high or it moves around a lot, it's hard for businesses to set the right prices and for people to plan their spending.

Because interest rates and inflation rates tend to move in opposite directions, the likely actions a central bank will take to raise or lower interest rates become more transparent under an inflation targeting policy. Advocates of inflation targeting think this leads to increased economic stability.

The Fed's goals of maximum employment and price stability are generally complementary. An economy with low and stable inflation provides economic conditions that are friendly to business planning, saving, and investing, which results in a growing economy. A growing economy needs workers to produce goods and services.

The Federal Reserve uses monetary policy to control inflation and keep it at or near an annual target of 2%.