Published on 04-15-2025
In 1977, Congress passed the Federal Reserve Reform Act, which defined the Fed’s dual mandate in qualitative terms as “maximum employment” and “stable prices.” It wasn’t until 2012 that the Fed formally announced that it would interpret its mandate of stable prices to mean 2 percent inflation based on the Personal Consumption Expenditure (PCE) price index. How did the Fed decide on 2 percent inflation as an appropriate definition of stable prices?
The most obvious definition of stable prices would be where the price level is constant over time. That is, relative prices could change but the overall inflation rate would be zero. (Following this definition of price stability, a penny would still be worth something and there would be no question about removing it from circulation.) As we increase the inflation rate away from zero, the price level is no longer stable. With a steady 1 percent inflation rate, the price level would double in around 30 years—roughly in a generation. Increasing the inflation rate to 2 percent results in a doubling of the price level in around 15 years. That is, the value of money would decline by half between our youth and early adulthood.
What are the potential benefits of a 2 percent inflation rate that might justify the lack of stability in the price level? One argument is that employers are reluctant to reduce a worker’s nominal wage. With 2 percent inflation, a zero nominal wage increase is in fact a 2 percent reduction in the worker’s real wage. However, with no inflation the employer would not be able to reduce the worker’s real wage without cutting their nominal wage. That is, a positive inflation rate helps the functioning of the labor market.
However, this argument relies on “money illusion”—that” is, that workers focus on nominal rather than real wages. While this might hold for short periods of time, we should not expect workers to be consistently duped. Similarly, in a zero-inflation environment, employers would soon lose their hesitancy to hand out nominal wage reductions when they are warranted. Competition would force their hands.
Another benefit of a 2 percent over a 0 percent inflation rate is in the ability of monetary policy to help achieve the second part of the Fed’s dual mandate, which is “maximum employment.” In the face of an adverse aggregate demand shock, the Fed can limit the impact on unemployment by lowering its policy rate. There are two channels of monetary policy that can support economic activity. The first channel is through shifting spending from the future into the present. Lower interest rates encourage spending today rather than saving and spending in the future. The degree of this incentive to shift the timing of spending depends on the degree to which the Fed can affect interest rates.
The second channel is through “wealth effects,” when appreciating financial assets stimulate spending. Consider the following simple example. Assume that the real short-term interest rate, r-star, is 1 percent and the Fed is keeping inflation at 2 percent. In this situation, the neutral nominal short rate is 3 percent. An investor purchased a 5-year Treasury Note at par value two years ago. In response to a downturn in the economy, the Fed cuts its policy rate from 3 percent to 0.25 basis points and the market expects the Fed to keep the policy rate at this level for 3 years. The lower policy rate will increase the value of this investor’s Treasury Note by 8.2 percent.
Now assume, instead, that the Fed had been keeping inflation at zero percent. In this case, its neutral policy rate is 1 percent instead of 3 percent as in our prior example. When the Fed cuts its policy rate from 1 percent to 25 basis points, the Treasury Note will increase in value by only 2.2 percent. The higher target inflation rate gives the Fed more ability to stimulate aggregate demand through both channels.
Former Fed Chair Alan Greenspan characterized price stability as a situation where inflation is at a low and stable level so that businesses and households don’t think about inflation in their decisions. This would certainly be the case with a target of zero inflation, but it might be more difficult for the Fed to meet its dual mandate from Congress with this choice. Like Sherlock Holmes’ 7 percent solution, the Fed’s 2 percent solution is meant as a stimulus when needed—in the Fed’s case for the economy.
Joseph Tracy is a Distinguished Fellow at Purdue University’s Daniels School of Business and a nonresident senior fellow at the American Enterprise Institute. Previously he was executive vice president and senior advisor to the president at the Federal Reserve Bank of Dallas.
