Two Percent Is Just A Number

There’s nothing special about the Fed’s target inflation rate

The Federal Reserve has aggressively leaned into its inflation-fighting role over the past year, which effectively means deliberately stripping workers of wealth and bargaining power via rate hikes without tackling the cause of our current inflation. One number that keeps coming up in all of the coverage: 2 percent. Reporters know that that’s the target inflation rate the Fed likes to see…but that’s usually where the conversation ends, even for some of the savvier journalists covering the central bank. The Fed will be satisfied when it gets the inflation rate down to the 2 percent target. But why? What’s so special about 2 percent?

In a lot of ways, nothing. That is simply the level of inflation that the Fed is comfortable with. The Fed’s mandate is to maintain price stability and full employment and, at some point, there emerged a consensus that 2 percent inflation was a good rule of thumb for stable prices. Some accounts suggest that the precise figure comes from a TV interview of New Zealand’s finance minister in the 1980s — not exactly rigorous policy development. As economist Veronika Dolar wrote in Fortune, “There isn’t any strong theoretical or empirical evidence for an inflation target of exactly 2%.” At this point, the target is more tradition than science. 

This is one of several ways in which what seem like deeply technocratic decisions are kind of arbitrary. For example, the Fed also always adjusts rates by multiples of 25 basis points (0.25 percent; 1 bp is 0.01 percent). There’s no reason they have to do it that way. They could raise it in increments of 10 basis points or 1 or 57 or whatever else they’d like. The 25 bp became standard largely because, in monetary policy, you want adjustments to be formulated around a base unit large enough that it can have an impact but small enough to not completely rejumble the economy. And 25 bp is good enough to be that baseline. It probably helps that 25 is a psychologically satisfying number; one quarter of 100 and all that. That’s the secret of macroeconomics: beneath the facade of hyper-technical math lies a lot of guesswork and approximation. 

After all, it is easier for us to conceptualize interest rates when policy uses nice round numbers. The macroeconomy is messy, with seemingly infinite data points and all kinds of measurements to try to make sense of them — some misleadingly so. We need to do some rounding and estimation to separate out the noise from actual important trends, and that means developing rules of thumb. That’s fine, as long as we’re all clear that that’s what we’re doing. But, the failure among policymakers and the media to reckon with that isn’t.

As we at the Revolving Door Project have written in the past, the Fed is obsessed with maintaining an air of unimpeachable professionalism and competence. That’s why their press director is literally the chief of staff of the whole institution.  The Fed constantly engages with the media and disseminates this exact type of technical analysis — without the background I’m telling you about. The media gatekeepers at the Fed are precise and respond rapidly to outlets that run afoul of their talking points. So much Fed reporting relies on unnamed sources talking about what an announcement signals, that no one wants to dig too deep into the policy itself, lest they lose those sources.

The worst part is that the broader commercial incentives of most financial media align with this deliberate incuriosity. Most financial news consumers are bankers, investors, and other types of professional financiers. They read financial media to help them make personal money-making decisions, not out of concern for the broader good of the American economy. 

Thus, the people who pay for the subscriptions that keep the lights on at places like The Wall Street Journal, Bloomberg, and so on really don’t care about why Fed Chair Jerome Powell has decided on the 2 percent mark as much as the fact that he has, and what that signals about how they should adjust their portfolio. To a professional financier, judging whether or not monetary policy is on the right track for the country matters far less than predicting where monetary policy is going next. The latter could let you make a lucrative trade, the former is so much politics. 

It’s seemingly to everyone’s benefit, then, to treat the 2 percent target as immutably wise and prudent. The Fed gets to look smart and professional, the journalists get to flatter their sources which helps them secure scoops, and the financiers get predictability which helps them make trading decisions. The only people who lose are the workers, who numerically are far more of the American people. But so long as everyone else excludes them and pretends that their suffering is just a side effect of the necessary medicine, everybody who’s in the club wins.

This alignment of professional incentives is why the way that I’ve been talking about interest rates and basis points here — as arbitrary guesswork — borders on heretical. Mainstream macroeconomists, and thus the reporters who cover them, like to take it as a given that these numbers are the laws of the universe. Powell, echoed by a host of pundits, constantly states how imperative it is to return inflation to the target rate of 2 percent.

In fact, there’s good reason to think that, in the current state of the US economy, slightly higher inflation is a good thing. According to the theory of secular stagnation, due to low growth rates (compared to the 20th century) and an aging population, monetary policy is becoming less effective and more likely to hit the dreaded zero-lower-bound — where interest rates are lowered all the way to 0 percent to try and force money out of savings and into the economy, but investment still stays weak. 

According to this theory, negative real interest rates will likely be required to stave off future recessions. (The real interest rate is the interest rate minus the inflation rate.) Several central banks have experimented with negative interest rate policies, where instead of them paying interest on deposits, they actually charge banks for having reserves. Notably, the European Central Bank and Bank of Japan have tried this, to mixed results. Somewhat elevated inflation means that the Fed can stimulate growth more, without having to take such a drastic step. The gist is that higher inflation gives monetary policy more runway to work with when fighting a recession. 

Interestingly, this theory largely gained prominence based on work by former Treasury Secretary and current pundit-cum-business consultant Larry Summers, who has now changed his tune, insisting that the secular stagnation he noted in the early 2010s was now gone because of higher inflation. However, other economists ranging from the left-leaning Economic Policy Institute to the neoliberal Peterson Institute for International Economics think that the current bout of inflation is more of a blip than a fundamental course change. As PIEE’s Olivier Blanchard put it, “global secular stagnation was and is driven by deep structural factors that neither COVID nor inflation have done anything to reverse.”

Another reason why treating the 2 percent target as gospel is misleading is that it ignores the other half of the Fed’s monetary policy job. The Fed is legally required to balance price stability with maintaining full employment. It would actually be more consistent with that mandate for the target rate to move based on how employment conditions are. The Fed decides what “price stability” means, but the unemployment rate and average pay determine when we’re at full employment. It’s very telling of the central bank’s priorities that it weights the factor which it defines for itself over the factor that’s more empirically observable.

Indeed, Robert Pollin and Hanae Bouazza of the Political Economy Research Institute (PERI) at the University of Massachusetts Amherst have conducted research that demonstrates that:

There is no evidence showing that economies at any level of development consistently experience stronger economic growth when inflation is maintained at less than 3 percent. On the contrary, our research finds that economies perform better at modestly higher inflation rates, within a 4–5 percent inflation range; and, in some circumstances, at higher rates still.

So, why does neither the media nor the Fed abandon their reverence for the sacrosanct 2 percent? 

Well, as I wrote back in the fall with Max Moran, the financial system is designed to serve the wealthy capital holders. As we put it back then:

Lest we forget who our financial system is set up to serve, it’s worth remembering that while inflation hurts everyone, unemployment only hurts working people. The wealthy don’t suffer when unemployment goes up – it just makes exploiting others’ labor cheaper! While it is true that inflation also hits the most vulnerable hardest, using that as grounds to make it harder for them to get good paying jobs is pretty sadistic. Given the choice between dealing with rising prices while having a job and a strong labor market or having no job at all, most of us would probably choose the former. 

The Fed has a dual mandate to maintain stable prices and full employment, but for almost all of the dual mandate’s existence, that second bit has generally gotten lost in the noise of economic discourse. It also can get overshadowed when the media constantly turns to wealthy establishmentarian economists like Summers who spoon-feed the talking points of capital-holders to reporters. The reason that inflation is being talked about as if it is a bigger threat than unemployment is that inflation impacts capital as well as labor.

Prioritizing inflation-fighting over employment will always be a part of this pattern. In a recent hearing, Senator Elizabeth Warren grilled Fed Chair Jerome Powell about hiking rates, asking him what he had to say to the millions of people he was trying to kick out of jobs. Powell bristled, firing back “Will working people be better off if we just walk away from our jobs and inflation remains 5%, 6%?”.

Well, compared to firing those working people, probably yes. The reality is that while the elites with whom Powell and other policymakers primarily associate are worse off with inflation, low-wage workers have actually seen wages rising faster than prices. 

This calculus about sacrificing working people’s wages in order to stabilize the macroeconomy and shore up capital holders is also why last weekend’s collapse of Silicon Valley Bank was such a shock to the finance world. That wasn’t supposed to be the cost of rate hikes. The monetary hawks agreed to shrink the economy by millions of jobs, but they didn’t agree to bank failures that impact their friends’ bottom lines. My colleague Max wrote in The American Prospect today about how predictable this was. In an accounting sense, the balance sheet exposure was clear as day. (Max has been on a roll this week, be sure to also check out his piece in The Nation about this type of hypocrisy around bailing out the rich while condemning millions to unemployment.) 

Philosophically, it came as a shock that interest rate hikes could actually punish the wealthy and corporations, because that’s not what we’re used to seeing. And while SVB’s failure could have been easily avoided, the fact that it wasn’t — the fact that the financial world started to face the side-effects of their own medicine — was scary to the comfortable. That’s why we saw such a fast mobilization of the Treasury Department, Federal Reserve, and Federal Deposit Insurance Corporation.

But now that irresponsible depositors have been bailed out, the question is whether the Fed will slow down its rate hikes next week to prevent further friendly fire. Perhaps we’ll see that the inviolable 2 percent rule can be bent if it’s in the interest of the financiers, if not for the commoners. To be fair, pundits a la Summers are calling for rate hikes to continue apace anyways. But to be fairer, they’ve pushed to create a sense of security among the finance world that the consequences are only for workers and capital holders will be protected.

Next time you see the 2 percent target, remember: 2 is just a number. The real situation is more complex.