2% Isn’t A Magic Number: Why The Fed Could Consider A Higher Inflation Target

With hotter-than-ideal inflation sticking around and the notion that we might need a recession just to meet the Fed’s (essentially arbitrary) 2% target seeming more laughable by the day, the buzz is growing – and it’s saying the Federal Reserve (the Fed) should rethink its long-standing 2% inflation target. So let’s take a look at what a higher inflation target might mean for you…

Why's everyone obsessed with this 2% thing anyway?

It wasn’t always this way. Sure, central banks have tried to maintain low and slow inflation for decades, but it wasn’t until the late 1980s that they started to think about price stability in terms of an actual percentage figure: 2%. And, even then, it was only because of an offhand remark made by a policymaker in New Zealand, a country that at the time was wrestling with some red-hot inflation.

The Fed informally adopted the 2% target sometime in the 1990s and officially stamped it as "the goal" in 2012. And it’s not just the Fed: central banks in the eurozone, the UK, Canada, Japan, and Sweden all have the same target. It’s considered a sort of Goldilocks inflation level: not so hot that it messes with household budgets and company spreadsheets, and not so cold that it stalls growth and hampers investment.

Sounds good on paper, but here's the kicker: that 2% isn't some divine number handed down from an economics deity. It's a number derived more by gut feel and historical side-eye than hard math. And there’s no real evidence that says 2% is better than 3% – or even 1.5%. It's a "seems about right" kind of deal that aims to keep the economy steady without throwing any curveballs.

So should the Fed consider a higher inflation target?

That’s a big debate at the moment – and there are some solid arguments in favor of nudging the target up to, say, 3% or higher.

It’d give the Fed more firepower against big, ugly recessions.

For all its power, the Fed has in its arsenal only so many weapons it can use against a job-killing recession. When nominal interest rates (that is, the interest rates before you take inflation into account) are already chilling at low levels, it leaves the Fed limited scope for making any economy-boosting interest rate cuts. And low or negative rates can pose some pretty big risks to the financial system. The other munitions at the Fed’s disposal – like quantitative easing (QE) – aren’t a lot better. They tend to be risky and their implications aren’t well understood.

A higher inflation target could lead to a simpler and more effective monetary policy. We're talking not just higher nominal rates (because lenders would demand higher interest rates to compensate for the loss of purchasing power) with more room for cuts but also lower real interest rates after you factor in that bumped-up inflation – all of which could be stimulative for the economy. Put simply, aiming for a higher inflation rate could give the Fed the ammo it needs to battle those downturns without resorting to financial wizardry (like QE).

It’d give firms more flexibility on wages, and incentivize them to invest more

Cutting nominal wages (that is, rate of pay before you take inflation into account) tends to be a no-go for most businesses, but higher inflation could provide a neat workaround: firms could let real wages slide without slashing the numbers on the paycheck, making it easier to adjust company costs. What’s more, inflation makes cash a hot potato: the faster it loses value, the quicker you want to spend it. So instead of parking their money in low-yielding assets, companies are nudged to invest in technology upgrades, research and development, or capital goods that promise better long-term gains. Plus if consumers expect higher future prices, they’re more likely to spend now, not later. Companies see that demand surge coming and are more inclined to boost capacity and go big on growth projects.

There mightn’t be a big difference between 2% inflation, and say, 3%

So everyone’s hung up on the 2% inflation target like it's some kind of golden rule. But let's get real: research shows people barely bat an eye until inflation tops 4%. As for those doomsday scenarios painting even low single-digit inflation as the enemy, well, the data doesn't really back that up. Few studies have even bothered to investigate the real costs of, say, 3% inflation, compared to 2%. Those that did found little evidence that a one-percentage-point bump higher has some disastrous impact on economic growth. In short, while we're all conditioned to see any inflation above 2% as a red flag, the reality might be a whole lot less dramatic.

The economic landscape is shifting

Over the next ten years, with the potential for slower growth, higher inflation, and ballooning government debt on the horizon, a higher inflation target could just be what’s needed. Elevating the inflation target could not only fuel more robust economic growth and make room for fiscal expansion, but also ease existing debt burdens. See, inflation erodes the real value of money, so by aiming for a higher inflation rate, those in debt – from Uncle Sam to you and me – could repay loans with "cheaper" dollars. It's essentially a subtle way for the government to reduce its own debt without resorting to less popular measures like tax hikes or spending cuts.

So why not raise the inflation target then?

If raising the inflation target was a sure-thing slam dunk, the Fed might’ve done it by now. But it’s complicated and there are plenty of reasons to argue against such a move.

There’s a risk the Fed would lose its credibility

If the Fed tweaks the target at a time when it's struggling to bring inflation to heel, it might look to some like it’s simply shifting the goalposts – and that could be a big knock against its credibility. That 2% target is the north star of economic expectations, and altering it could send those expectations spiraling into chaos. That’s why Ben Bernanke, one of the Fed's former head honchos, set that 2% target in writing in the first place back in January 2012. His concern was (and is) that if the Fed comes off as too aggressive in changing its target, people might think it's getting political or planning to monetize the debt, essentially signaling a compromised Fed. With credibility as fragile as Grandma's antique vase, that’d be a huge risk to take.

Inflation really is public enemy No. 1

If there’s one thing that consumers, workers, and investors agree on, it’s that inflation is the bad guy here. It leaves consumers feeling poorer. Higher inflation makes life complicated: shopping turns into a frustrating exercise in sticker shock and assessing investments becomes like trying to hit a moving target. Plus, there are always companies that try to take advantage of consumers, jacking up prices to more than compensate for their increased costs. And let's not forget the curveball: not all prices inflate at the same speed. That means the whole system can get wonky and unpredictable, causing resources to be wasted or misallocated. Whatever the true costs of inflation, we have to recognize that the psychological costs of high inflation are real, and that can, in turn, lead to some real economic consequences.

Inflation expectations could become unanchored and inflation very volatile

Messing with the inflation target isn't just tweaking a number – it's like lighting a fuse on a powder keg of public and market expectations. This target serves as an anchor for everyone from consumers to investors. Lift it, even a bit, and you could spark a wildfire of uncertainty. Employees could demand higher wages, businesses might hike prices, and just like that, we've got inflation behaving like a hyperactive squirrel. The impact on financial markets could be even larger: borrowers might demand a much fatter premium to compensate for that risk, sending interest rates soaring, driving up government deficits, and reducing private investment. In short, a higher inflation target could swap a set of manageable issues (like a more limited arsenal for battling recessions) for the risk of permanent financial instability.

It erodes purchasing power and increases inequalities

Think of inflation as a stealthy wealth shifter: while it nibbles away at purchasing power for everyone, it’s taking bigger bites from some and smaller bites from others. For instance, the wealthy often have inflation-resistant assets like stocks or real estate, but your everyday savers might not. And with inflation, they’ll see the value of their nest egg erode. Retirees and other people on fixed incomes may find daily living costs harder to meet. Meanwhile, inflation can push up interest rates, making debts costlier for those without fixed rates on what they borrow. And let's not forget wages: some workers can negotiate pay raises that are in line with inflation, but lower-income workers more often see their purchasing power slip because of inflation. And while an extra percentage point a year in price increases may not seem massive, it adds up over time.

So what’s the big investing takeaway then?

The debate might be sizzling on whether the inflation target should be cranked up, but don't expect the Fed to get hot under the collar. For one, the central bank’s not likely to gamble its hard-earned street cred on a high-stakes bet with shaky payoff prospects. Plus, it's got to nail its current 2% target – consistently – before anyone buys the notion that the Fed’s not just moving the goalposts because it can't score.

Still, don't write off a target change altogether. Eyes are on 2025 for a strategy revamp, though it's far from certain that we'll have inflation on a leash by then. In the interim, stocking your portfolio with commodities might just be a savvy move. We could see "higher for longer" inflation or a target bump, and commodities could cash in under either scenario.