Are Inflation Targets Still On Point?

The Federal Reserve Act mandates that the Federal Reserve conduct monetary policy “so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." Of late, just two words—stable prices—are receiving outsized attention. The broad language in the Act leaves a lot of room for interpretation: What range of price changes are considered stable?

This question vexes central banks around the world. Most have adopted inflation targets, and in developed markets, almost all of them center around 2%. But the post-pandemic period has initiated scrutiny of this figure. Should it ever change, and what circumstances would justify an adjustment? These questions hover like a large shadow over today’s monetary policy.

Before any central bank ever set a numerical target, they operated under the impression that moderate inflation is healthy, but extreme inflation is not. When prices rise too rapidly, consumers fall behind and struggle to keep pace: the result can be a wage-price spiral or a collapse in demand, both regrettable.

Deflation (broadly declining prices) is also economically damaging. In this latter case, businesses’ margins shrivel, and they respond with rapid job cuts, ensuring a recession.

The right answer is a Goldilocks state of inflation, neither too hot nor too cold. Steady economic activity and growth of the supply of money will lead to moderate inflation and predictable interest rates.

Inflation targeting policies have value beyond monetary policy decision-making. The International Monetary Fund (IMF) looked back at central banks’ performance against their targets, concluding that targets help to anchor inflation expectations. This is an important goal of monetary policy. The clear objective also informs other decisions, such as structuring fiscal policy with an eye toward managing inflation.