Judging by previous posts in the site, the inflation target is set annually to 2% by the Federal Reserve. Regardless of the reasons behind this choice, I am curious to understand how precisely can the Federal Reserve aim for a value (maybe understanding the means they use to control it will be enlightening for that purpose). Could it be set, for the sake of the example, to 1.9% instead? Or to 1.95%?


What is the resolution down to which the annual inflation value can be controlled?

They can target arbitrary number. For example, they can target $1.9999\%$ or $3.1415\%$.

Could it be set, for the sake of the example, to 1.9% instead? Or to 1.95%?

Yes, it could. However, the target inflation rate is more or less aspirational and it is the value Fed aims to hit on average over the business cycle rather than maintain it at all times (in fact the target is not just $2\%$ but $2\%$ over the long run (see official Fed explanation here). Fed has dual mandate of keeping price stability and full employment. Following both of these objectives requires that inflation is sometimes above $2\%$ and sometimes below. In fact recently Fed chairman announced that in the near term they want to target inflation moderately above $2\%$.

In addition, note that Fed is not expected to hit its target with surgical precision. Consequently, there is not much point in setting it to $1.95\%$. For example, if Fed would keep the $2\%$ but inflation over long-run would happen to average at $1.95\%$ they would likely consider it a success since it is close enough to their target. Even though Fed can control inflation, price level (change in which gives you inflation) depends also on random macroeconomic perturbances/shocks. Consequently, most economists would not consider it a failure if average inflation deviates from its long run target by just $0.5\%$.

Regarding the means Fed has to control inflation there are several ones. Following, Blanchard et al. Macroeconomics central banks can control inflation via:

  • It can do it via changes in the interest rates (this is one of the most common ways).
  • Direct changes to the money supply.
  • Changes to the reserve requirement (currently abolished in the US).

An important caveat is that Fed is also institutionally constrained in the use of the above. For example, helicopter money is one way how central bank could expand money supply from economic perspective, but it might not be legal in the US (it is highly questionable). Fed can still affect money supply in other ways such as open market operations but these constraints mean that sometimes Fed cannot go as far as it would want with expansion of money supply.

Some other instruments are constrained by economic reality. For example, Fed cannot set interest rates too low as there is effective lower bound on how low the Fed funds rate can go. Typically models show it is at zero interest rate (although practically it is possible to go bit below) because cash has implicit $0\%$ interest rate and thus if Fed would set its rate significantly below zero (which would make commercial banks to go below zero as well) people would just refuse to keep their money in their banks and just keep cash (the interest rate can go bit negative as there are storage costs for keeping large sums of cash at home).

However, going over every minutiae detail of how Fed is constrained by law or economics would be beyond the scope of SE answer, but you should keep in mind that there are asterisks to the above.

  • $\begingroup$ Thanks. Summarizing your answer, if I understand it well, the accuracy to which the target can be met is around 0.5%, and the measures the Federal Reserve can trigger to achieve this are rather approximative, leading to the results indirectly (more interest rates tend to produce based on historical results less of this or that, etc., etc.) instead of having a direct control of it. $\endgroup$
    – A. Frenzy
    Feb 21 '21 at 21:43
  • $\begingroup$ @A.Frenzy it is not that simple, in theory Fed can be as precise with hitting its target as it wants. In practice it might have harder time hitting it in some periods and others depending on macroeconomic situation, but that misses the whole point. Fed is not even trying hit some precise number at all times. Feds job is to maintain price stability and full employment and not trying to zealously follow the target no matter what cost to the economy. The target is manly Feds way of communicating with public and helping to anchor inflation expectations, if Fed is able to achieve precisely 2% $\endgroup$
    – 1muflon1
    Feb 22 '21 at 9:27
  • $\begingroup$ over long run but having inflation of 2.3% over long run in next 10 years will better for the economy, and in another 10 years 1.9% would be better they will try to hit those numbers and won't necessary change their target. For example, since central bank is supposed to hit the target in a long-run (which is usually approximately period of 10 years but it does not have set time length - long run is simply time period over which prices are flexible) it is possible that first 3 years is some heavy recession requiring 4% inflation then another $\endgroup$
    – 1muflon1
    Feb 22 '21 at 9:37
  • $\begingroup$ 5 years there might be expansion requiring 1% inflation that averages to 2.125%. Well Fed will not zealously try to pursue lower inflation (as that requires contractionary monetary policy that lowers further employment and output) in expansion just to hit exact number 2% because what would be the point, the 2.125% is close enough to its target as to not undermine Feds credibility (if Fed would just lie about pursuing 2% people would stop believing Fed and it would loose its ability to change market expectations by talking, but if it hits it close enough it won't have negative effects) $\endgroup$
    – 1muflon1
    Feb 22 '21 at 9:39
  • $\begingroup$ so even if Fed could hit its target with surgical precision the point is they are not even trying. Regarding, its practical ability to hit the target that depends on macro situation. In a liquidity trap Fed might have problem to hit target even by 1-2% in more stable times it might have ability to hit its target even by 0.1%. In fact if Fed would be completely unconstrained and its only mandate would be to always hit 2% every year, it would probably be able to do that in most years with high precision but that would not allow them to pursue their mandate of full employment. $\endgroup$
    – 1muflon1
    Feb 22 '21 at 9:44

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