Why the Fed’s Inflation Target Is More Rhetoric Than Reality (April 21, 2024)

History shows prices have long exceeded the 2% target. The number is haphazard and the timing undefined.  

By Lisa Beilfuss
April 21, 2024

If actions speak louder than words, it may be fair to say that the Federal Reserve’s commitment to a firm 2% annual inflation target has long been illusory. Many investors may thus be underestimating the central bank’s current inflation tolerance.

After the latest round of inflation data dashed hopes that accelerating prices in the first two months of the year were blips, many economists flipped into the no-interest-rate- cuts-this-year camp. Some are going further to say more monetary policy tightening is warranted. 

But it is worth taking a step back. Consensus expectations for Fed policy are built on the Fed’s stated commitment to its 2% inflation target. “The Committee is strongly committed to returning inflation to its 2% objective,” the central bank’s policy setting committee has said in each of its post-meeting statements since June 2022. After decades of deliberation, the Fed established its explicit target under Ben Bernanke in 2012. The long debate back then is relevant to circumstances now.

Matthew Wells of the Richmond Fed describes how the inflation-target debate started and evolved. Alan Greenspan in the mid-1990s tasked Al Broaddus, then president of the Richmond Fed, to make the case for a target. Among his arguments: the Fed’s credibility rested not only in managing actual inflation, but in its ability to shape inflation expectations. A target could help anchor inflation expectations, and prices themselves, providing markets with more certainty around Fed policy and price stability.

Greenspan meanwhile tapped current Treasury Secretary and then-Fed governor Janet Yellen, first appointed in 1994, to present arguments in opposition of an inflation target. Yellen’s arguments centered on concerns that such a target would cause monetary policy to prioritize inflation over employment. 

Wells says that in July 1996, after officials seemed to secretly settle on 2%, Greenspan reminded members to keep the discussions confidential. “With an eye on potential political and market blowback, [Greenspan] warned, ‘I will tell you that if the 2% inflation figure gets out of this room, it is going to create more problems for us than I think any of you might anticipate.’” Among them: being on the hook to effectively cause unemployment when inflation runs above target.

Flash forward to March 2007, after Bernanke succeeded Greenspan as Fed chair. Some officials, such as then-Dallas Fed president Richard Fisher, altogether opposed the idea of an inflation target. Yellen, then San Francisco Fed president, came to favor a target range of up to 3.5% and preferred it be a long-run goal and not bound by a fixed time horizon. Bernanke argued that 2% would be “the lowest inflation rate for which the risk of the funds rate hitting the lower bound appears to be acceptably small.” Yet it didn’t take long for rates to hit the zero lower bound, where they stayed for six years, and for the Bernanke Fed to concurrently launch massive bond-buying programs.

A walk through the history of inflation targeting, which often credits New Zealand’s central bank for creating the 2% target to establish independence from the political process, makes it clear that 2% is somewhat arbitrary. Don Brash, atop New Zealand’s central bank when the target was adopted 35 years ago, reportedly said the number was “plucked out of the air.” 

Now consider Fed Chair Jerome Powell’s new emphasis on getting inflation back to 2% “over time.” In his March press conference, he used the phrase in that context eight times in the hour-long session. If the number is haphazard and the timing is undefined, the trusted 2% target seems hollow.

This isn’t altogether new. I recently revisited a data set I first wrote about in November 2021. The New York Fed’s Underlying Inflation Gauge, or UIG, sought to measure persistent inflation. This measure typically comes in lower than the CPI and PCE. The indicator was last released in October, at which point it was discontinued. 

At its last measurement, the  UIG fell to an annual pace of 2.9%. That is down significantly from a peak of 6.3% in June 2022. But it was still well above the Fed’s 2% target–which is based on core, as opposed to persistent, inflation–and it came before inflation began to reaccelerate.

What is more, the UIG shows how comfortable the Fed is with above-target inflation. The last print simply put the gauge back to mid-2018 levels. Despite the narrative that for years before the pandemic the Fed couldn’t get inflation off the floor, the UIG averaged 2.5% in the year before the pandemic, 2.6% in the two years before the pandemic, and 2.5% in the three years before the pandemic. And that is just underlying inflation, as opposed to total inflation. The UIG undershot CPI by an average of 62 basis points for 2023 before it was scrapped and by an average of 200 basis points and 100 basis points for 2022 and 2021, respectively.  

Central bankers are expressing particular concern over housing inflation. "I have been expecting [shelter inflation] to come down more quickly than it has. If it does not come down, we will have a very difficult time getting overall inflation back to the 2% target," Chicago Fed President Austan Goolsbee recently said.

Some say that using private data instead of the government’s shelter measure is more accurate. Plugging in Zillow’s observed rent index pulls the March CPI down to 2.7% from 3.5%. But using the Zillow gauge also means that CPI in the years leading up to the pandemic trended closer to 4%. 

Here is a real-world anecdote behind the data. Gavin Campbell, founder of real estate private equity firm Steelbridge, says his firm’s annual apartment and single-family home rental growth for the 10 years preceding the pandemic was never below 3%. Renewals, which represent 70% of Steelbridge’s leasing, never grew below 4% annually. 

“Rents in our portfolio bottomed a year ago [and] are only going up from here,” Campbell says. In addition to strong job growth, he says high mortgage rates are driving the increases. “Don't expect any CPI help from shelter absent a recession or interest rate cuts from the Fed,” he says. 

Last week, the Labor Department said its new all-tenant rent index rose 5.4% in the first quarter, matching the fourth quarter’s gain. Rick Palacios, research director at John Burns Research & Consulting, says single-family asking rent growth is 4% or more in 54 of the 99 markets the firm tracks.Las Vegas is the only market declining, and just barely.  

All of this may help answer a question posed by former Fed economists Robert Brusca. How can a central bank retain credibility if, instead of defending an inflation target it has overshot for two-and-a-half years, it defends an unemployment rate that is near a half-century low? 

If the 2% inflation target has always been more about perception than reality, without reality matching perception, then now might be a good time for investors to doubt consensus expectations for Fed policy.