The Federal Reserve Board and the 2% Solution

At his first press conference of the new year, Federal Reserve Board chairman Jerome Powell made it clear monetary policy is on cruise control for now, despite increasing pressure from the new administration to approve more interest rate cuts.

“The public should be confident that we will continue to do our work as we always have, focusing on using our tools to achieve our goals and really keeping our heads down and doing our work,” he said.

Deftly sidestepping questions about the possibilities of political interference in Fed policymaking decisions, Powell refused to directly address administration calls for a less restrictive monetary policy stance saying, “I’m not going to react or discuss anything any elected politician might say.”

While the focus on presidential rhetoric on interest rates was to be expected, a more fundamental question went largely unnoticed in the aftermath of the late January press event.

Asked about the Fed’s 2% inflation target as part of its dual mandate of price stability and maximum employment, Powell quickly dismissed the idea that the central bank might want to reexamine the policy.

“I think the goal has served us well over a long period of time,” he said. “It’s also sort of (a) global standard. I think that if a central bank wanted to look at changing that you wouldn’t do it at a time when you’re not meeting it anyway. I mean, there’s just no interest in changing it. We’re not going to change the inflation goal anytime soon.”

While some might praise the Fed’s consistency in adhering to the 2% inflation target as providing a firm foundation for interest rate calculations, the measure is neither rooted in deep economic theory nor any kind of historical benchmark.

The 2% target was only made explicit and public in 2012 and price stability was only officially established as part of the Fed’s mandate with the passage of the Federal Reserve Reform Act of 1977.

But a lot has changed in the last dozen years, and the nature of the U.S. and global economies face a variety of new challenges as we enter the second quarter of the 21st century.

The Covid-19 pandemic showed just how interconnected the global economy really is and the logistical snafus that tied up supply chains were just one of the stark reminders that we live in a very different economic world today. The spike in inflation that followed the “end” of the pandemic should have been a wake-up call that our assumptions about inflation – and how to combat it – might just need some recalibration, starting with the Fed’s adherence to the 2% target.

As for Powell’s contention that with inflation running above the 2% goal it is not the time to change it, that just doesn’t make sense.

According to that logic, if inflation does fall to 2% and the decision is made to redefine the target at 2.5%, that means immediate interest-rate hikes to bring inflation up to the new target level. Besides being a wildly unpopular move, it is also likely to trigger an economic crisis. If a policy change is in the offing to raise the target rate, it only makes sense to do it when inflation is already above the 2% level to realign the price stability mandate with new economic realities.

In dismissing any consideration of a policy change, Powell may just be playing it safe, hoping the Fed can weather the political pressures it is likely to face in the coming months and years. But if he and his colleagues are serious about maintaining central bank independence, this may be the perfect time to reconsider those policy goals.