The Economist explains: Why the Fed targets 2% inflation

by / Sunday, 13 September 2015 / Published in Economy

ON SEPTEMBER 17th the Federal Reserve will conclude a two-day, rate-setting meeting at which it just might raise its benchmark interest rate for the first time in more than nine years. Arguing in favour of a hike is the low unemployment rate, which fell to 5.1% in August. Arguing against it is the rate of inflation which, having come in at 0.3% year-on-year in July, is well below the 2% target that is the lodestar of Fed policy. But why does the Fed want 2% inflation in the first place?Central banks are responsible for monetary policy: roughly speaking, the job of controlling the amount of money that courses through the economy. For a long time, monetary policy consisted of little more than stabilisation of the exchange rate, which was often fixed (eg by the gold standard at the beginning of the 20th century) in order to facilitate international commerce. But exchange rates proved a poor target for policymakers. Pulling money out of the economy to buoy the currency and protect the exchange rate could send the economy into a tailspin; such policies helped create the Depression of the 1930s.After the Depression governments prioritised domestic employment. Central banks reckoned the economy followed a relationship known as the Phillips curve, which posits a trade-off between inflation and unemployment; governments could have less of one if they were prepared to accept more …
Source: The Economy