Latest / Inflation Explained with Fexingo: CPI, Prices, and the Cost of Living for Everyday People / Why Two Percent Inflation Target Is Wrong for 2026
Transcript
- Lucas: So the latest core PCE reading came in at 2.4 percent. That's the Fed's preferred inflation gauge, and it's been hovering around there for months now. Luna: Right, above their two percent target, but not by a huge margin. And yet they're still holding rates at three-point-six-three percent. Lucas: Exactly. And if you look at the labor market, we just saw nonfarm payrolls add only fifty-seven thousand jobs in June. Unemployment ticked up to four point two percent. And here's the kicker: the labor force participation rate fell to its lowest level in fifty years, outside of COVID. Luna: So fewer people are even looking for work. That's a structural issue, not just a cyclical one. Lucas: Which brings me to the question I think a lot of people are quietly asking: does the two percent inflation target still make sense for the economy we actually have in 2026? Luna: It's a good question. I mean, the two percent target wasn't handed down on stone tablets. It has a history. Lucas: Right. It started in New Zealand in 1990. The Reserve Bank of New Zealand was the first central bank to adopt a formal inflation target, and they picked zero to two percent. Other countries followed, but the number wasn't based on some deep economic theory. It was more like: we need a number, let's pick something low and credible. Luna: And then it became the global norm. The Fed didn't explicitly adopt two percent until 2012, under Ben Bernanke. Lucas: Exactly. And the logic at the time was partly about the zero lower bound on interest rates. If inflation averages two percent, then nominal rates have room to be cut during recessions without hitting zero. But that logic assumed a world where neutral interest rates were higher than they are today. Luna: And now we're in a world where the neutral rate might be lower, and we've seen inflation run above two percent for years. So why cling to a target from 1990? Lucas: Well, one argument is credibility. If you change the target, markets might think you're just moving the goalposts because you missed. But let's be honest: the Fed has already been tolerating above-target inflation for a while now. Core PCE has been above two percent since early 2021. Luna: So we're already effectively living with a higher target, but the official target hasn't changed. That creates confusion. Lucas: Exactly. And there are real economic arguments for a higher target. For one, it gives the Fed more room to cut rates in a downturn without hitting the zero lower bound. If inflation averages three percent, then nominal rates can be around five percent normally, giving you more ammunition. Luna: Also, higher inflation can help reduce real debt burdens. If you have a fixed-rate mortgage, higher inflation erodes the real value of what you owe over time. Lucas: That's a point that doesn't get enough airtime. For households with debt—and that's most households—moderately higher inflation isn't necessarily bad. It's workers with fixed wages who get squeezed, but if the labor market is tight, wages can keep up. Luna: And we've seen some wage growth in the past couple of years, though it's cooled recently. Lucas: Yeah, average hourly earnings are up about four percent year-over-year, but that's been slowing. The bigger issue is housing. Shelter inflation is still sticky, partly because of how the CPI measures it, but also because there's a genuine shortage of affordable housing. Luna: So raising the target to three percent wouldn't fix the housing shortage, but it might change the policy mix. If the Fed isn't fighting the last war against inflation, maybe they'd be more supportive of fiscal solutions. Lucas: Right. And look at what's happening globally. Christine Lagarde at the ECB is leaving the door open to an early exit, and she's dealing with French political turmoil. The ECB has a target of two percent too, but they're facing different realities. Luna: It feels like the whole central banking world is in a kind of orthodoxy that's starting to crack. You've got academics like Olivier Blanchard and others arguing for a higher target. Lucas: Blanchard has been making that case for years. He says three percent or even four percent would give central banks more room to manage recessions. And he's not alone. But the political optics are tough. If you say 'we're raising the inflation target,' people hear 'we're going to make your cost of living go up on purpose.' Luna: Which is a hard sell when people are already feeling squeezed. But the current approach isn't exactly painless either. We've got elevated interest rates, a cooling job market, and a housing market that's frozen because nobody wants to give up their three percent mortgage. Lucas: That's the lock-in effect. Existing homeowners are sitting on low-rate mortgages, so they don't move. That reduces supply in the housing market, which keeps prices high. And it's partly a consequence of the low-rate environment the Fed created during the pandemic. Luna: So the two percent target, combined with the pandemic response, created this distortion that we're still living with. Lucas: Exactly. And this is why the conversation about the target matters. It's not just an academic debate. It affects the real economy—your mortgage, your job, your rent. Luna: You know, this kind of nuanced economic thinking is exactly why we keep this show ad-free. We don't have to sell you anything or dumb it down for sponsors. If walking through the economy with us has made something click, and you want to support that, there's a link: buy me a coffee dot com slash fexingo. Lucas: Yeah, it's a small way to keep us independent. No pressure, but it does help us keep the conversation going. Luna: Alright, back to the target. So if the Fed were to raise its target, what would that actually look like in practice? Lucas: Well, they'd have to communicate it very carefully. Probably a gradual process, maybe announcing a review like they did in 2019. That review led to the flexible average inflation targeting framework, which basically said they'd let inflation run above two percent for a while to make up for periods below two percent. Luna: But that framework hasn't exactly worked as planned. They overshot, and then they had to hike aggressively. Lucas: Right. So maybe the next step is to formally adopt a higher target. But there's also the risk that if you change the target, expectations become unanchored. People start to think inflation could go anywhere. Luna: That's the credibility argument. But if you look at the breakeven inflation rate, it's at two point two five percent. Markets seem to expect inflation will stay around there. Lucas: Which suggests that the two percent target is still credible in the bond market. But the question is whether that's the right number for the real economy. And I think the answer is increasingly no. Luna: So what's the alternative? Three percent? Four percent? Or something more flexible, like a range? Lucas: A range might be the most practical. Say two to four percent, with the midpoint at three. That gives the Fed some wiggle room without looking like they're abandoning discipline. And it would align better with the actual inflation we've seen over the past five years. Luna: It would also reduce the frequency of hitting the zero lower bound. In a world where neutral rates are lower, a higher target gives you more buffer. Lucas: Exactly. And it might even help with the housing lock-in effect. If people expect three percent inflation, then a three point five percent mortgage isn't as attractive as it used to be, but it's not a penalty either. It could unlock some mobility. Luna: So maybe the biggest barrier is political will. Who wants to be the Fed chair that formally raises the inflation target? Lucas: Probably no one right now. But economic conditions have a way of forcing changes. If we hit a recession and the Fed can't cut rates enough, the conversation will shift fast. Luna: And with the labor force participation rate at fifty-year lows, we might already be in a different structural environment. Lucas: That's the key. The two percent target was designed for a world with a growing workforce, higher productivity, and higher neutral rates. None of those are true today. So maybe it's time to ask: what's the target for? Luna: And the answer might be: it's for a world that no longer exists.