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Jerome Powell and his colleagues at the Federal Reserve have a North Star – a 2% target for the U.S. inflation rate. I mean, it's more than a North Star. It's their religion, their obsession, their reason for living. They do everything possible to reach the 2% target inflation rate. The U.S. Federal Reserve isn't the only bank in love with the 2% target inflation rate. Canada, Australia, Japan, Sweden, Colombia, and Israel are other economies after the 2% target. It seems so much the global economy, daily news, conversation on social media, and everyday investors' decisions are based on or about this elusive 2% inflation target. What's so magical about a 2% inflation rate? Who says a 2% target is right, and what happens when we finally reach the 2% target? What do we, the individual investors, should know about the inflation target? Let's talk about that!  I'm Hoda Mehr, founder, and CEO of Stock Card, and on this blog and its accompanying YouTube channel and Podcast show, I share detailed fundamental analyses and interesting investment stories.
This post is part of a series I started a few weeks ago to fundamentally research companies to manage my real-money portfolio. I've already researched Canopy Growth (CGC), Fastly (FSLY), Snap (SNAP) , Shopify (SHOP), Airbnb (ABNB), Unity (U), JD.com (JD), NVIDIA (NVDA) and several others. I'll continue with this series for a few more weeks. Remember, this content is for education and sharing ideas and not advice to buy or sell any securities. Sign up for a free account on Stock Card to get notified of these blog posts, YouTube videos, and Podcast shows every week. We only ask your name and email address when you sign up. As an investor, fintech founder, and economist by training, I'm fascinated by the 2% inflation target and all the action it brings to the stock market. The story of where the target comes from and its presumably magical power is worth our attention. From outside the Federal Reserve and in the media and the minds of the good citizens of the nation, we assume the 2% inflation target results from sophisticated financial modeling and years of experimentation by economists and statisticians over the optimal level that oils the wheels of the economy. That seems to be the right way of coming up with an important target for the world's largest economic power. But, if you dig further, the 2% target is apparently a historical accident. Chairman Volcker Had No Inflation TargetWe've heard Chairmen Jerome Powell referencing Chairman Volcker's heroic efforts in combatting inflation and bringing the inflation rate back under control. In the 1970s, inflation was rampant in the U.S. When Chairman Volcker took over the Federal Reserve in 1979, inflation was 11% and still rising. He raised the interest rates to almost 20% to control it, causing sky-high unemployment and two back-to-back recessions in 1980 for six months and in 1981 & 1982 for more than a year. By early 1983, inflation retreated to just over 3%. Notice that the inflation wasn't 2% when the Fed felt it had managed to control it, and neither was it at the 2% level by the time Chairman Volcker left the Fed in 1987. Indeed, our hero, Fed Chair Volcker, never looked for, targeted, or achieved a 2% inflation rate. There was no specific inflation target for much of the economic history globally. The federal reserves of the world all aim to reach price stability. Until New Zealand came up with a fixed target, no other economy was focused on reaching a set inflation rate. New Zealand Created The Fixed Inflation TargetNew Zealand was the first country to come up with a fixed target in 1989. Canada, the UK, Sweden, and other nations picked up the fixed target regime in the years to follow. You'd think the New Zealand government had a good reason and study done to create a fixed target. Alas, the fixed target was born out of a television interview. In the 1980s, New Zealand was battling a high 15% inflation rate and had managed to bring it down to 10% by 1988. The country's finance minister, Roger Douglas, was pressed during a television interview, and he mentioned that he ideally wants to get to a zero to 1 percent target. After the television interview, The Reserve Bank of New Zealand felt it must put some credibility behind the minister's words on TV and use the opportunity to come up with a more concrete inflation-fighting plan. Their economists did some basic calculations to factor the difficulty of accurately measuring the inflation rate and introduced an official 2% target to its economy and a fixed inflation target system to the world. I couldn't make up a more ridiculous story for the origin of a global move toward a fixed inflation target than what the world's economists, finance ministers, and central banks have come up with themselves. Where Did U.S.'s 2% Inflation Target Came From?Back in the U.S., we know there was no specific target when Volcker left the Fed. If it wasn't Volcker, who did all the scientific work to come up with a 2% target? When Alen Greenspan took over Volcker, he commissioned Fed economists to devise a target. At last, someone wanted to do it in the right way. But, sadly, the economist charged with the task came back and said the project would be a huge computer simulation study and requires putting the U.S. through another recession so they could test the sensitivity of inflation to various interest rate levels. Of course, no Fed Chairman wants to be blamed for intentionally creating a recession, so the study was put on the back burner. If the economist didn't do the study, where did the 2% target in the U.S. come from? According to the transcript of an FOMC meeting in 1996, Chairman Greenspan, a Fed Official named Janet Yellen (yes, the same Janet, the Treasury Secretary now), and other officials were discussing a target. Greenspan wanted to reach some level of price stability where price increases don't impact businesses' and households' decisions. Yellen insisted on putting a number on that stable price level. They discussed that measuring inflation accurately is hard, but moving toward a 2% inflation target seemed good, and they will get a sense of the economy as things pan out. Oh, and Volia, my fellow investors, the U.S.'s 2% target was born. Initially, the 2% target was a more like a yardstick for the Fed until 2012, when Chairman Bernanke officially announced it as our nation's inflation target. This is not to say that Chairman Greenspan, Janet Yellen, and other Fed officials and economists didn't know the implication of putting an arbitrary target for the inflation rate. It speaks more about the complexity and the distance between economic theories and the real world. That makes you wonder why all the fuss about the 2% target and why the Fed is still trying to reach the 2% target if it is a made-up number without concrete evidence that reaching it will have the desired effect on the economy. I want to wrap up by imagining the day we hit the 2% target and see what would happen then. What magical chest of gems will we open when we get there? What Happens When We Hit 2% InflationThe short answer is that Nothing will happen when we hit the 2% inflation rate. This is not a password to some sort of economic growth that suddenly gets unlocked at 2%. The long answer is that in an ideal situation, when we hit the 2% inflation rate, there will be a psychological effect. Managing inflation is all about signaling to the consumers that they can save and buy without worrying about losing their purchasing power in the future and to the businesses that they can invest in producing their goods and services and benefit from reasonable growth in the future. It is a sublet psychological balance when consumers and businesses feel "good" about today and the future. So, it isn't the 2% itself that matter, it's the implication of hitting that target that matters most. The two percent level seems to be some sort of a sweet spot. Hitting a two percent level is low enough for consumers' mindset but relaxed enough for the economy to grow. It is also possible that we never actually hit the 2% sharp. For years, inflation hovered above and below the 2% target, and the Fed focused on the average 2% target instead of hitting the actual 2%. In other words, in an ideal world, once we hit the 2% rate, or somewhere in its vicinity, the topic of the inflation rate will drop out of the public's immediate attention, and no one will worry about it anymore. Not worrying about inflation is the best outcome we can hope for when we hit the target. I'll see you next time!
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