Background: The Fed inflation target

The Federal Reserve has a 2 per cent inflation target. But that simple number conceals a monetary policy framework that has evolved substantially over the past half-century.

Importantly, the Fed does not target the widely reported Consumer Price Index. Its target is 2 per cent annual inflation in the Personal Consumption Expenditures (PCE) price index. PCE covers a broader range of household expenditure and adjusts more readily when consumers change what they buy. The target refers to headline PCE inflation, although policymakers closely examine core measures when assessing underlying inflation pressure.

Nor does 2 per cent mean prices should return to their previous level after an inflationary episode. If prices rise 10 per cent and inflation subsequently returns to 2 per cent, the higher price level generally remains. The Fed targets the rate of change in prices, not the price level.

From Volcker to an explicit target

Modern US inflation policy was shaped by the Great Inflation of 1965–82, when inflation eventually approached 15 per cent. Paul Volcker's Federal Reserve responded with severe monetary restraint from 1979, accepting recession and sharply higher unemployment to re-establish price stability and policy credibility.

Under Alan Greenspan, inflation settled near 2 per cent without a formal numerical target. Internal FOMC discussions in 1996 show policymakers already debating whether approximately 2 per cent represented effective price stability. The Fed switched its preferred inflation measure from CPI to PCE around 2000.

Only in January 2012 did the Fed formally announce that 2 per cent PCE inflation was its longer-run objective. In 2016 it clarified that the target was symmetric: persistent inflation below 2 per cent was undesirable as well as inflation above it.

Then came another significant experiment.

In 2020, after years in which inflation had tended to undershoot 2 per cent and interest rates repeatedly approached zero, the Fed adopted flexible average inflation targeting. After prolonged periods below 2 per cent, it would deliberately tolerate moderately above-target inflation for a time. The theory was that this would keep average inflation and inflation expectations around 2 per cent while giving monetary policy greater room to support employment during downturns.

That framework did not survive the post-pandemic inflation shock.

Following its 2025 review, the Fed abandoned the explicit “make-up” strategy and returned to flexible inflation targeting. The 2 per cent destination remained unchanged, but the Fed no longer promises to compensate for previous undershoots with subsequent overshoots. Its current framework instead stresses keeping longer-term inflation expectations anchored and balancing inflation and employment risks across different economic circumstances.

Should 2 per cent remain the target?

That question remains contested.

Economists favouring a 3 per cent target argue that slightly higher normal inflation would produce higher nominal interest rates, giving the Fed more room to cut rates during recessions before reaching zero. Olivier Blanchard has advocated 3 per cent on these grounds. Former Fed chair Ben Bernanke has acknowledged the theoretical argument but warned that abandoning a target established over decades could damage hard-won credibility.

Others favour a target range, such as 1.5–2.5 per cent, recognising that inflation cannot be fine-tuned to a decimal point. More radical alternatives include price-level or nominal-GDP targeting, which would require policymakers to compensate systematically for previous misses.

For now, however, the Fed has decisively retained 2 per cent. Its September 2026 projections show PCE inflation at 3.7 per cent in 2026, 2.3 per cent in 2027 and finally 2.0 per cent by 2029. That illustrates how inflation targeting actually operates in practice: 2 per cent is an anchor, not a requirement that inflation equal 2 per cent every month or even every year.