The Fed’s 2% Inflation Target Is No Longer Enough

Federal Reserve Chair Jerome Powell held interest rates steady Wednesday for a third time this year, citing inflation running above the central bank’s 2% target.

Christine Lagarde, the president of the European Central Bank, has also recently warned of “higher inflation and lower growth” this year, citing energy shocks, geopolitical risks, and a high degree of uncertainty. Alberto Musalem, president of the Federal Reserve Bank of St. Louis, cited those same forces as likely to result in “persistent above-target inflation throughout 2026,” which would justify the central bank holding interest rates higher for longer.

None of these bank officials have called for raising the inflation target. They don’t have to. The implication is clear: Central banks are preparing the public for a world in which inflation persistently overshoots 2%.

Oil shocks and heightened geopolitical tensions have reignited a familiar debate about whether policymakers should formally raise their inflation targets or simply take a mulligan and recommit.

But whether the inflation target “should” be 2% or 3% or some other number is beside the point. That argument misses the purpose of monetary policy.

Monetary policy is about stabilizing the demand-side of the economy so the supply-side of the economy can produce as much as possible. Inflation targeting is one strategy for doing that, but it isn’t the best one, nor the right one, given our brave new world of frequent supply shocks.

The right target of monetary policy is nominal gross domestic product: the total value of all goods and services in a given year in current dollars. When nominal GDP is stable, households and firms can more easily make long-term plans. Entering into contracts becomes more straightforward. Durable investments become less risky. Guided by the price mechanism—capitalism’s greatest asset—the economy self-coordinates.

Central banks often try to use inflation targeting as a proxy for demand stabilization. Keep inflation at 2%, the thinking goes, and the rest will take care of itself. When the supply side is stable, that approximation works well enough. But supply-side stability is a thing of the past. With wars raging, trade tensions rising, and energy prices unstable and creeping upward, monetary policymakers have lost their foothold.

There is really nothing monetary policy can do about supply shocks. If wars destroy wealth or scarce oil drives up production costs, the world’s economies will become poorer. No amount of interest-rate adjustment can refine undelivered oil, unclog ports, or conjure new productivity.

The central bank’s responsibility is to keep markets working as well as possible by not compounding the problems. Demand-side stability becomes even more important amid supply-side instability. Targeting nominal GDP rather than inflation can minimize the damage from supply shocks. As in medicine, the first principle of policymakers is “do no harm.”

Yet this is precisely where the current monetary policy framework fails. Because central bankers focus on inflation as the target, they treat supply-driven price increases as if they were signs of excess demand. The usual policy response—slowing down nominal GDP growth—actually compounds the economic harm. Output growth stalls or reverses. Employment suffers.

Viewing things this way helps explain what went wrong at the Federal Reserve over the past several years. The problem wasn’t that inflation rose and stayed above 2%. Rather, it is that nominal GDP surged far beyond any reasonable path in 2021 and 2022, and policymakers failed to correct it in time. They have been playing catch up ever since.

This is why arguments over the “right” inflation target are misguided. Raising the target from 2% to 3% ignores the underlying problem, which is that monetary policymakers aren’t paying enough attention to the main indicator of demand, nominal GDP. As a result, they have lost credibility as capable macroeconomic stewards.

Households and businesses instinctively understand this. They might not be able to get into the weeds of the finer points of monetary policy, but they rightly sensed the central bank’s shortcomings in recent years. Credibility erodes not because inflation is occasionally above target, but because central banks can’t distinguish supply problems from demand problems.

It is time to target nominal GDP directly. Under a nominal GDP target, the central bank commits to a predictable trajectory for total dollar spending in the economy. If spending runs above the path, policy tightens. If it falls below, policy loosens. Supply shocks change the composition of growth—for example, oil shocks result in temporarily faster price growth and temporarily slower job growth—but don’t trigger destabilizing policy responses.

This approach achieves two major goals the current framework cannot. First, it cleanly separates demand from supply. Monetary policy focuses on what it can control, namely overall spending, and leaves real adjustments to the real economy. Second, it anchors expectations. Businesses and households don’t need to guess how policymakers will weigh inflation against employment or financial conditions. They know the total spending path will be maintained.

Monetary policy can’t bring back the era of supply-side tranquility. It can’t guarantee growth and prosperity. But it can provide a stable economic environment in which markets adjust to reality rather than being whipsawed by policy.

It may not be perfect, but it is the best we can do. And compared with our current shortcomings, that is more than good enough.