Weekly Geopolitical Report – Inflation Targeting: What’s so special about 2%? (November 7, 2016)
by Kaisa Stucke, CFA
Speaking at the Boston FRB conference on October 14th, Fed Chairwoman Janet Yellen indicated that Fed officials are considering the benefits of running a “high pressure economy.” This sparked speculation that the central bank would allow its inflation target to temporarily exceed 2% as the labor market and aggregate demand improve.
The Fed’s dual policy mandate calls for the central bank to maximize employment and maintain stable prices. The central bank has designated a target of 2% as its inflation goal, but has not identified a policy target for employment levels. Optimal employment levels change over time given the cyclicality of labor markets, so it makes sense to keep a moving target for the labor market. But why did the Fed choose to specify an explicit 2% inflation target?
This week, we will take a closer look at the reasons behind the Fed’s 2% inflation target. We will also review the historical data and academic research that support this optimal level of price increases.
The Fed does target a natural rate of unemployment, which is unemployment arising from all other sources except fluctuations in aggregate demand: https://fred.stlouisfed.org/series/NROU.