Chainkeen|Should the Fed relax its 2% inflation goal and cut interest rates? Yes, some experts say.

Two percent inflation is Chainkeenmore than just the Federal Reserve’s goal, one could argue, as it works to wrestle down pandemic-related price increases that have plagued U.S. households over the past three years.

It’s the Fed’s holy grail. Its lodestar. Its mantra.

Lately, though, the 2% target feels more like the economy’s Godot – a remedy to its inflation woes that seemed tantalizingly close not long ago but now appears further away, raising questions about whether it will arrive at all.

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The dilemma may have significant implications for consumers, investors and the U.S. economy. Fed officials have said they won’t start cutting interest rates – which would lower borrowing costs for millions of Americans, boost economic growth and further juice a bullish stock market – until inflation “is moving sustainably toward” the 2% target.

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But with the economy showing early signs of faltering, some top forecasters are increasingly asking some version of this question:

What’s so magical about 2%?

And does the Fed really need to wait until inflation approaches the seemingly sacrosanct objective to start trimming its key interest rate, which has hovered at a 23-year high since last summer?

“I don’t think 2% is the right number,” says Mark Zandi, chief economist of Moody’s Analytics. “Don’t sacrifice the economy on the alter of the 2% target.”

Other forecasters say the Fed has no choice but to stick almost religiously to the 2% goal so that consumers and businesses believe the Fed will do what it says and yearly price increases really will fall to 2%. If people don’t expect inflation to slow to 2%, that itself could keep inflation elevated.

“The worry is you lose credibility,” if the Fed monkeys with the target, says Jonathan Millar, Barclays' senior U.S. economist.

Where did the 2% inflation target come from?

The Fed raises its key short-term interest rate to increase borrowing costs and cool the economy and inflation. It lowers the rate to reduce rates on credit cards, mortgages and other loans, and jumpstart growth.

New Zealand was the first country to adopt a 2% inflation target in the late 1980s. The Fed privately embraced the benchmark in the mid-1990s but didn’t formally announce it and make it part of its policy until 2012. Many other developed regions – including Europe, Japan and Canada – have 2% inflation goals.

In the decade after the Great Recession of 2007-09, annual inflation mostly languished below 2% because of a glacial recovery from the crisis. By 2019, the Fed tweaked the goal and stated that it would aim for inflation that averages 2% over time, allowing the measure to hover somewhat above the target for a while to make up for periods when it fell short.

That, officials hoped, would help jolt a listless economy.

How did the pandemic affect inflation?

The new approach became irrelevant as the pandemic, and the nation’s recovery from it sparked booming growth along with inflation that soared to a 40-year high. The Fed, in turn, hiked its federal funds rate from near zero to a range of 5.25% to 5.5%.  

Last year, as pandemic-related product and labor shortages largely resolved, the Fed’s preferred measure of core inflation – which excludes volatile food and energy items – tumbled rapidly from about 5% to 3%. Fed officials forecast three rate cuts in 2024, propelling the stock market to record highs.

But since December, with inflation running hot, the price gauge has been stuck at 2.8% to 2.9%, tossing some cold water on the market rally. A better – but still not great – inflation report last week cheered investors and drove the Dow Jones Industrial Average to close above 40,000 for the first time Friday.

Most economists, and futures markets, now expect the Fed to reduce rates once or twice this year.

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What will inflation be in 2024?

Here’s the problem: If monthly price increases slow from the recent range of 0.3% to 0.4% to a more typical 0.2%, as many economists expect, Millar reckons that would still leave annual inflation at 2.9% by the end of the year, above March’s 2.8% reading. That’s because monthly price gains eased substantially during the second half of 2023, widening the gap between price levels a year ago and what they’re likely to be later this year.

So does that mean rates stay where they are?

Not necessarily. Fed Chair Jerome Powell has said that inflation doesn’t need to be at 2% for officials to start cutting rates as long as it’s moving sustainably in the right direction. If monthly price increases edge down to 0.2% in coming months, that should be enough for the Fed to lower rates once, in September, even if yearly inflation remains high, Millar says.

But it wouldn’t take much to undercut even that middle-ground scenario. If monthly price bumps average 0.3% the rest of the year – just a tick higher - that would leave annual inflation at a whopping 3.8% by December, says Gregory Daco, chief economist of EY-Parthenon. In that case, don’t expect any Fed rate cuts in 2024.

What is causing high inflation?

Just a few products and services are keeping inflation elevated.

A persistent rise in housing costs has made up 36% of monthly price increases, according to one inflation measure. Rent has declined for tenants signing new leases but that shift has been slow to filter into existing leases. And if a quirky and controversial measure of rent for single-family homes is removed from the Fed’s preferred price measure, inflation is already below 2%, Zandi says.

Also, car insurance premiums were up 23% annually in March – even though new vehicle prices have dropped after a pandemic-induced spike – because it takes time for state regulators to approve insurance companies’ proposed rate increases. But smaller increases or declines should be on the way.

The cost of financial services has risen sharply because of the market rally, which has increased investment-company fees that are based on a percentage of the assets they manage.

The outlook for these costs isn’t affected by interest rates, Daco says, and so they shouldn’t cause the Fed to keep rates high.

Millar disagrees, saying that high borrowing costs can discourage hiring and slow pay increases in other industries, like car repairs and haircuts, pushing down inflation overall.

Is the US job market good right now?

Fed officials have said they can afford to wait for inflation to ease before lowering rates because the economy and labor market are still sturdy, with monthly job growth averaging a robust 245,000 this year.

 Zandi and Daco, however, see signs of weakness. Just 175,000 jobs were added in April. And while net monthly payroll gains have been strong this year because of low layoffs, hiring and the share of workers switching jobs have dipped below prepandemic levels. An underlying measure of retail sales dropped in April. And low- and middle-income Americans are struggling with record credit card debt and historically high delinquencies, Zandi and Daco say.

With the economy wobbling, “Something could break,” Zandi says. “Why take a chance” by keeping rates high?

Is 2% a good inflation rate?

Zandi argues the 2% inflation target no longer makes sense. With the economy’s potential growth lower than it was in the 1990s, he says the Fed should tolerate 3% inflation so its long-term interest rate can be higher, giving officials more room to cut it in a recession before it reaches zero.

And Daco advocates for allowing some wiggle room around the 2% target so the Fed has more flexibility to respond to unforeseen economic developments.

Should the Fed raise its inflation target?

Here’s the rub.

The Fed can’t adjust its 2% inflation goal because “the credibility of that target” would be “undermined severely,” Millar says.

The public would think that just because it becomes tough to lower inflation “you throw in the towel,” he says. On the belief that inflation will stay elevated, workers would ask for bigger raises and companies would boost prices more sharply, perpetuating high inflation, Millar says.

Also, many investors have bought bonds with returns that modestly top inflation on the expectation the Fed will keep inflation at 2%. If the central bank modifies the goal, “It’s almost like you’re reneging on a contract,” he says.

When can we expect the Fed to lower interest rates?

Yet exactly when the Fed lowers rates is a judgment call. Powell has said officials could cut even if inflation stays elevated if the labor market weakens unexpectedly. Zandi and Daco think that’s already happening.

Daco believes the Fed will start reducing rates in July. “Only time will tell” if cutting in September, as markets predict, means the Fed will have waited too long and sparked a recession, he says.

In other words, although the Fed can’t officially change its inflation target, it could err on the side of trimming rates sooner than later, knowing the goal doesn’t need to be so rigid, Zandi and Daco say.

Don’t hold your breath.

At news conferences, Powell has firmly dismissed suggestions the Fed could be content with inflation that settles above 2%. This month, he said, “Well, of course, we’re not satisfied with 3% inflation. ‘Three percent’ can’t be in a sentence with ‘satisfied.’”