The inflation rate is a key indicator of economic health and managing the rate is one of the primary responsibilities of the United States Federal Reserve. Historically, when the Fed hints at making any changes to it’s monetary policy their efforts are closely watched by economists and investors alike. In this article, you’ll learn about the Fed’s long-standing 2% inflation target, what it means and how it affects the economy.
What is the Fed’s 2% Inflation Target?
The Federal Reserve Board has set a long-term goal of 2% inflation as its inflation target since 2012. This means the Federal Reserve tries to manage the economy so that prices of goods and services increase by 2% each year. When prices rise by less than 2%, it’s called disinflation. When prices rise by more than 2%, it’s called inflation.
Inflation is a normal part of the economy. It’s generally thought of as a good thing because it helps to stimulate economic growth. It encourages people to buy now, before prices go up, and helps businesses to maintain their profits. The Federal Reserve uses its inflation target of 2% to make sure the economy isn’t expanding too quickly or too slowly.
Why the Fed Chose 2%
The 2% inflation target is based on an idea known as the “non-accelerating inflation rate of unemployment” or NAIRU. The concept of NAIRU is that when unemployment rises or falls to a certain level, there is no longer an effect on inflation. This level has been identified as an optimal level, and so 2% was chosen as the inflation target.
In addition, 2% is seen as an appropriate rate of inflation because it’s slightly higher than the long-term rate of inflation in the US, which has been running at about 1.5%. This provides the Federal Reserve with a level of stability, allowing them to make gradual changes to monetary policy when needed.
How Does the Fed Achieve Its 2% Inflation Target?
The Federal Reserve uses two main tools to achieve its 2% inflation target. The first is setting interest rates. By adjusting the federal funds rate, which is the rate commercial banks and other financial institutions are charged for borrowing money from the Federal Reserve, the Fed can influence the amount of money circulating in the economy.
The second tool the Federal Reserve uses is controlling the money supply. The Fed can increase or decrease the amount of money in the economy by buying and selling government securities. If the economy needs more money, the Fed will purchase securities, which increases the money supply. If they feel like there’s too much money in the economy, they can sell off securities to reduce the money supply.
Effects of the 2% Inflation Target
The 2% inflation target has a number of effects on the US economy and financial markets.
Positive Effects
Low and stable inflation helps keep economic growth steady. This means businesses and consumers can plan for the long-term and makes it easier to set prices and salaries. Low inflation also keeps interest rates lower, which means cheaper borrowing costs for businesses and consumers and more investment in the economy.
Negative Effects
On the flip side, the Fed’s 2% inflation target can lead to problems. If the Fed sets monetary policy too aggressively and the inflation rate falls below 2%, it can lead to deflation and a recession. This means prices and wages go down, which can hurt the economy.
The Federal Reserve’s 2% inflation target serves as an important guideline for setting monetary policy. The target helps the Fed strike a balance between stimulating economic growth and keeping inflation under control. While the policy does have both positive and negative effects, it’s generally seen as a necessary tool for maintaining an optimal level of economic growth and stability.
