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.[1]  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.

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[1]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.