An explanation of the Federal Reserve's 2% inflation target

According to the Federal Reserve Bank of St. Louis, the 2% inflation target is essential to the Federal Reserve's plan for stable prices in the American economy.

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According to the International Monetary Fund, a number of economies include 2% in their inflation rate targets, including Canada, Australia, Japan, and Israel.

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The Economic Policy Institute's Josh Bivens, head of research, told Trade Algo that the "2% inflation objective" is "pretty arbitrary."

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So where did this dream of a 2% inflation rate come from? 

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You might assume that... Perhaps in the Bible, God declares that he desires 2% inflation, joked Laurence Ball, an economist at Johns Hopkins University and a consultant to the IMF, in an interview with Trade Algo.

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Oddly, it was created in New Zealand, according to Ball.

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Trade Algo, therefore, contacted various economists from New Zealand.

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According to Victoria University's Arthur Grimes, who teaches public policy and wellness, "we pioneered inflation targeting."

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When newly-minted Ph.D. economist Grimes began his work at the central bank, which at the time was not independent of the government, New Zealand was experiencing extremely high inflation in the late 1980s.

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"Well, if we achieve independence, what should our goals be?' we said. The money supply or interest rates? Grimes uttered, "

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And I recently said, "Well, actually, what are we attempting to accomplish? We are working to stabilize prices. Why don't we just set a target for inflation? ’”

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Inflation targeting was established by the Reserve Bank of New Zealand Act of 1989, and today it is practiced in economies all over the world. In 1991, Canada declared its inflation target, and in 1992, the UK did so. Later, according to the Organization for Economic Cooperation and Development, Sweden, and Finland set inflation objectives in 1993.

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The United States didn't announce its 2% inflation rate target until 2012.

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Since then, there has been debate over whether or not that aim is appropriate.

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For instance, in 2017, some economists argued in favor of a higher target in a letter to the Federal Open Market Committee.

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One of the experts who signed the letter, Ball, stated that there is "no evidence that 3% or 4% inflation does substantial damage relative to 2% inflation."

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But, as the world adjusts to a new post-pandemic normal, central banks' inflation targets have come under increased scrutiny.

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According to Thomas Hoenig, a former president of the Federal Reserve Bank of Kansas City, "it is, I think, an error to suggest 2% is somehow magically the right figure."