The Fed’s Arbitrary 2 Percent Inflation Target and a More Accountable Monetary Policy

At the end of his tenure as Fed chair in 2013, Ben Bernanke spoke at the commemoration of the Federal Reserve’s centennial. “We must continue to emphasize two other essential values—transparency and accountability,” he said, reflecting on the central bank’s evolving role. “Ultimately, the legitimacy of our policies rests on the understanding and support of the broader American public, whose interests we are working to serve.”

Why does democratic accountability at the famously independent Fed matter, and what might that accountability look like today? We can begin to answer this question by interrogating a central orthodoxy of US monetary policy: the Fed’s 2 percent inflation target.

To help ensure democratic accountability, and ultimately monetary policy decisions that align with the public interest, Congress should claim a greater and more proactive role in overseeing the Fed’s approach to inflation targeting.

Since the 1977 Federal Reserve Reform Act, the Fed has been statutorily required to pursue price stability and full employment, but that mandate has no legally binding quantitative inflation target. While a later law, the Humphrey-Hawkins Act, set numerical goals for the following decade, it left Congress empowered to revise them over time. However, the Fed itself, not Congress, has charted the path to the now- conventional 2 percent target.

Both inflation targeting as a monetary policy approach to price and labor market goals, and the 2 percent target in particular, should face greater public scrutiny. To help ensure democratic accountability, and ultimately monetary policy decisions that align with the public interest, Congress should claim a greater and more proactive role in overseeing the Fed’s approach to inflation targeting. After all, as Bernanke told his successor Janet Yellen in 2013, “Congress is our boss.”

The Evolution of Inflation Targeting Without Congress

Given the ubiquity of inflation targeting among the world’s central banks over the past 25 years, it’s tempting to think that both the practice and the well-known 2 percent number rest on solid foundations. One might also assume that the Fed’s 2 percent inflation target is a statutory requirement, or, at the very least, derived from macroeconomic modeling. In reality, it is neither.

While the Fed’s price stability mandate dates back to 1978, inflation targeting is more recent. In the Greenspan era (1987–2006), the Fed internally and privately adopted a 2 percent target, but it was not until 2012 that the Federal Open Market Committee (FOMC) officially and explicitly adopted the target under Bernanke, who was committed to clearly communicating that target. But the Fed was markedly more reserved about justifying its choice of 2 percent, specifying only that the FOMC judged it to be “most consistent over the longer run with the Federal Reserve’s statutory mandate.”

Where did the 2 percent number come from? Far from resulting from robust congressional (or academic) debate about how best to balance the public’s interest in price stability with competing macroeconomic goals, the initial selection of the 2 percent figure was essentially arbitrary, with its origins in the Reserve Bank of New Zealand’s early experiments with inflation targeting in the late 1980s. The Reserve Bank of New Zealand arrived at the figure unsystematically, anchored on an off-hand remark by the then-finance minister. Other major central banks eager to embrace inflation- targeting converged on 2 percent as a target, with the central banks of Canada and England—and later the Fed and European Central Bank—joining suit. As this approach has become normalized and institutionalized, the perceived credibility costs of switching away from it have supplanted accountability and narrowed the potential monetary policy reforms.

An arbitrary inflation target is inherently undemocratic, and the choice of target has real stakes for the broader public. Selected without public debate or input, and subject only to the internal deliberations of a small group institutionally separated from representative government, the 2 percent target has grown ever more insulated from public challenge, critique, or change.

But inflation targeting as a policy—and maintaining a 2 percent target specifically—has consequences that directly affect the public. While Fed Chair Warsh has repeatedly insisted there is no inherent trade-off between the Fed’s two goals of full employment and price stability, arguing that managing inflation is good for workers, the two goals do stand in tension: Higher levels of employment are generally inflationary, though the relationship is complicated. At least in the short run, a myopic focus on inflation targeting may come at the cost of workers. Fed policy actions to achieve 2 percent inflation can have uneven distributional impacts as they are transmitted throughout the broader economy, directly affecting the cost of credit. These trade-offs argue against purely technocratic policy changes sequestered from popular input.

An arbitrary inflation target is inherently undemocratic, and the choice of target has real stakes for the broader public.

Alternatives Are Possible, but Central Bankers Are Conservative

Strictly hewing to a 2 percent target has real costs, which justify its reevaluation. As former Fed Vice Chair Alan Blinder reflected in his 2017 remarks at the Bank for International Settlements’ annual conference, “Suppose we had had better foresight back then, and accurately foresaw a world with lower real rates and recessions far deeper than the Great Moderation experience had led us to expect . . . Would the consensus still have settled on 2 percent measured inflation? Maybe not.”

Economists like Olivier Blanchard have argued since at least 2010 that a higher inflation target would provide the Fed with more room to cut rates during economic crises without hitting the zero bound of interest rates. A decade later, the Powell Fed’s COVID-era embrace of a “flexible average targeting” framework amounted to an awkward acknowledgement that a strict 2 percent target during times of economic distress was inappropriate. But even amid this inflation-targeting framework change, the 2 percent number was treated as sacrosanct, demonstrating the challenges of deviating from that target once set.

Even without taking a strong position on whether and under which circumstances inflation rates should be higher than 2 percent, policymakers have made compelling arguments both for and against strict inflation targeting more generally—including among members of Warsh’s own recently convened task force on inflation.

Related questions like how we choose to measure inflation, what is included and excluded, and how we calculate the potential impacts of AI investment on price levels and the expected short-term interest rate remain contested issues, each with significant consequences for American consumers, borrowers, and investors. Just because these questions are often technical does not mean they are apolitical.

As Roosevelt Chief Economist Joseph Stiglitz said in his 1997 Tinbergen lecture, “The fact that monetary policy involves trade-offs . . . has one clear implication in a democratic society. The way those decisions are made should be representative of the values of those that comprise society.”

Ultimately, the Fed should be accountable to the people most impacted by its decisions. Anyone who earns a wage, owns a credit card, or needs a loan is affected by how the Fed manages inflation and what it deems an acceptable level of inflation for the economy.

A Path Back to Accountability

While transparency is important, accountability for inflation targeting goes beyond one-directional Fed communications—the public must also be able to influence the Fed. In practice, this means a greater role for Congress, not just to set inflation targets, but to take action on fiscal, housing, regulatory, and energy policy when the Fed’s conventional tools fail to bring down inflation.

Specifically, Congress should require annual justifications from the FOMC of their choice of inflation target, in writing, ahead of congressional questioning and debate. This would have two immediate benefits: It would incentivize Congress to develop more expertise on monetary policy, and empower it to ask better-informed and tougher questions during the Fed chair’s semiannual appearances before Congress—in line with recommendations elsewhere in this collection. As Binder and Spindel (237) note, “There is [currently] little payoff for electorally minded lawmakers to spend time or resources examining the Fed’s performance.”

More frequent hearings on the topic of the Fed’s inflation target would allow members of Congress to publicly demonstrate to their constituents (and party leadership) their commitment to holding the Fed accountable—and it would make failures to do so more visible. It would also incentivize the Fed to explicitly justify its choice of inflation target, something it has seldom done, even in its initial public announcement of the 2 percent target in 2012. When the Fed consistently fails to meet its inflation target—or when Congress determines that the Fed’s inflation target is no longer serving the public interest—Congress should be proactive about using its legislative authority to influence the Fed’s inflation-targeting strategy, and to embrace a wider range of policies to bring down inflation that remains resistant to costly interest rate hikes.

The idea of Congress imposing greater accountability and transparency on the Fed is not new. In the 1970s, Congress required the Fed to hold semiannual hearings about Board and FOMC monetary policy to adhere to the dual mandate of price stability and full employment. In 2000, Congress required the Fed to provide members with written reports and to provide greater public access to information on its website. However, in charting the history of the relationship between Congress and the Fed, Binder and Spindel find that congressional attention to the Fed is almost exclusively reactionary: Congress takes action to reform the Fed only after crises happen.

Making Fed policy more systemically accountable demands a more proactive Congress: one that does not wait until the depths of stagflation to consider imposing greater accountability on the Fed. Binder and Spindel argue that this reactive relationship has served the interests of both members of Congress and the Fed. The Fed offers lawmakers eager to escape blame for economic downturns the political cover of a villain, and Congress shields the Fed from both greater accountability and, generally, from the kinds of intervention that might jeopardize its credibility. But while a generally quiescent and sporadically reactive Congress may benefit lawmakers’ electoral calculations and the Fed’s desire to avoid messy public confrontations, this current state of affairs emphatically does not serve the interests of the public.

There is, to be sure, no ironclad guarantee that a Congress more proactively involved in inflation targeting would serve the public’s interests either. Annually revisiting the Fed’s inflation target would come at a cost, potentially to the Fed’s credibility. After commenting on the inappropriateness of the Fed’s 2 percent target to the Great Recession era, Alan Blinder went on to say, in 2018, “Central banks have since . . . staked a great deal of their credibility on the 2 percent inflation target—and especially on its role as the nominal anchor for inflation expectations. To pull up the anchor now could risk a severe loss of credibility—raising questions, for example, about when the target might be changed again.”

This is a valid concern. Frequent, arbitrary, and unpredictable revisions to the Fed’s inflation target would indeed jeopardize the monetary credibility on which price stability rests. However, myopic adherence to a target the Fed cannot meet except at great cost and with unusual luck, or to one that does not afford the Fed adequate room to respond to recurrent economic crises, also undermines the Fed’s credibility. That credibility should not be assumed. Among the public, the Fed is already perceived as a political actor.

Mandatory public justifications for selecting monetary targets, with the possibility of greater congressional action if these targets are found wanting, would provide a framework for the Fed and Congress to balance monetary credibility and a wider set of macroeconomic policy goals.

Democratic control contains no guarantees of sound outcomes. The wager of this proposal is that more accountable processes are more likely to generate accountable outcomes than unaccountable processes. This is not certain and requires that the actors holding the Fed to account value expertise, research, and the public interest. Ultimately, a Fed that is more accountable to Congress is not guaranteed to enact a monetary policy that better serves the broad public—but the alternative is an arbitrary and unaccountable approach in which no empowered actors’ incentives align with those of ordinary Americans.