If any of our clients are more than a casual observer to the financial markets, they have heard from any number of talking heads on CNBC or Fed Chair Jerome Powell himself that once inflation gets to 2%, Federal Reserve officials can relax and cut interest rates further. Well, where did this 2% target come from?
This WT Wealth Management Learning Spotlight traces the origins and rationale behind the now-ubiquitous 2% inflation target.
In 2025, a 2% inflation target is central to monetary policy in most developed economies. It’s embraced by the U.S. Federal Reserve, the European Central Bank, the Bank of England and the Bank of Canada as an interest rate target benchmark for price stability.
Yet, the 2% target was not derived from economic theory or empirical necessity. Rather, it evolved through pragmatic decisions, historical precedent, and institutional learning.
In the decades following World War II, central banks operated without formal inflation targets. Economic priorities were centered on full employment, and inflation was often tolerated as a byproduct of growth. However, the 1970s shattered that framework. A rare combination of high inflation and stagnating growth—termed “stagflation”—undermined public trust.
Seemingly, suddenly, economists emphasized that inflation is fundamentally a monetary phenomenon, and that central banks must focus on controlling the money supply to maintain price stability. The universal idea that low and predictable inflation fosters economic stability began to take root.
The breakthrough came in New Zealand. In the late 1980s, facing persistent inflation, the country overhauled its monetary framework. The Reserve Bank of New Zealand Act of 1989 gave the central bank operational independence with a mandate to ensure price stability. In 1990, New Zealand Reserve Bank Governor Don Brash announced an inflation target range of 1 to 3% by 1992.
Although 2% was somewhat arbitrary, it was perceived as low enough to signal credibility while giving policymakers some flexibility. As the New Zealand economy stabilized, the midpoint of that range, 2%, began to gain symbolic importance. Other central banks took notice.
Following New Zealand’s example, a wave of countries adopted formal inflation targeting in the 1990s and early 2000s. The consistency of the 2% figure across countries reinforced its credibility. Though each central bank tailored its communication and time horizons, the adoption of a clear numerical target—often centered on 2% provided transparency and anchored inflation expectations.
The U.S. Federal Reserve was slower to adopt an explicit inflation target. Guided by a dual mandate from Congress—to promote both maximum employment and stable prices—it hesitated to commit to a single number.
For decades, U.S. Federal Reserve policymakers preferred strategic ambiguity, fearing that a fixed target might limit flexibility. Nevertheless, by the mid-1990s, internal discussions and policy behavior indicated that the Fed also preferred 2% inflation, measured by the Personal Consumption Expenditures (PCE) index. The 2% PCE target balanced the risks of inflation and deflation while providing enough nominal interest rate room for policy adjustments.
It wasn’t until 2012, under Chairman Ben Bernanke, that the Fed officially adopted a 2% inflation target. This move, coming in the aftermath of the Great Recession, aimed to increase transparency and guide financial markets in an effort to reduce volatility.
The 2% inflation target did not emerge from a grand economic theory. It began as a pragmatic choice in New Zealand and spread globally because it worked. The 2% target offered central banks an easy-to-communicate policy anchor. Over time, it became institutionalized across major economies, including the United States.
While debates continue about the 2% target in a low-interest-rate world, the current target remains a symbol of central bank credibility and commitment to price stability around the world.
The WT Wealth Management Learning Spotlights are designed to inform, inspire, and foster meaningful dialogue between our clients and the WT Wealth Management team. Our goal is to demystify complex economic and investment topics, offering clear, practical insights that connect financial theory to real-world decisions.
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