The Federal Reserve’s 2% Inflation Target Increases Government, Taxpayers and Product Costs

 November 10, 2024

The Federal Reserve’s 2% inflation target, set in 2012, under the Obama Administration, has led to a cycle of automatic growth in federal spending on entitlements, salaries, and debt servicing, ultimately impacting government budgets and taxpayers. Initially intended to foster economic stability, this target has also elevated government costs, placing an increased burden on taxpayers.

The 2% inflation target affects federal spending by raising costs across inflation-adjusted entitlements, pensions, and other federal programs. This inflation rate is factored into cost-of-living adjustments (COLAs) for Social Security, federal pensions, and certain welfare programs. These adjustments directly increase the baseline of entitlements, which comprised 55% of federal expenditures in 2023. Social Security, Medicare, and Medicaid are among the most significant beneficiaries of these inflation-based adjustments, with even a 2% increase leading to substantial cumulative costs when applied across millions of beneficiaries.

Roughly 50 to 60 federal programs—including Social Security, Medicare, Medicaid, and veterans' benefits—are linked to annual inflation adjustments based on the Federal Reserve's target. Many of these programs use the Consumer Price Index (CPI) as a benchmark for COLAs. Given entitlement spending of approximately $3.3 trillion annually, a 2% increase translates to an added $66 billion in entitlement outlays alone. This figure excludes other inflation-sensitive government expenses, such as federal employee salaries, which collectively amplify the budgetary impact and taxpayer burden.

The broader implications of the Fed’s 2% inflation target extend beyond its stated goals of maximum employment, price stability, and moderate long-term interest rates. While the target aims to stabilize prices, it inadvertently raises government costs, driving the need for increased revenue through taxation or borrowing. Experts and I suggest that a ZERO inflation target would alleviate these pressures while still supporting the Federal Reserve’s objectives.

How the Fed’s 2% Inflation Target Affects Government Costs and Taxpayers:

1. Automatic Increases in Federal Spending: Many federal programs, such as Social Security, Medicare, and federal pensions, include cost-of-living adjustments (COLAs) that are typically linked to inflation metrics like the Consumer Price Index (CPI). With a 2% inflation target, these programs automatically adjust upwards each year, which increases federal spending and contributes to the national debt if revenues do not grow at the same rate.
2. Impact on Federal Salaries and Benefits: The federal workforce’s salaries and benefits are often adjusted to reflect inflation. A consistent 2% annual inflation guarantees that costs will rise in line with inflation targets, impacting government budgets and adding to long-term fiscal pressures. Pensions for retired federal employees and military personnel are also tied to inflation, increasing automatically. This means the government’s financial obligations grow each year, leading to compounding expenses.
3. Increased Debt Servicing Costs: As inflation increases, so does the interest rate environment (although not in lockstep), which can raise the cost of servicing the national debt. With the federal government’s debt currently exceeding $30 trillion, even a small increase in interest rates due to inflation can add hundreds of billions of dollars in additional costs. This is especially relevant in periods when interest rates rise in response to inflation—for example, the recent hikes to counteract high inflation—making debt financing more expensive.
4. Long-Term Growth in Government Budgets: A sustained 2% inflation target implies that the government's annual budget must grow to account for inflation-adjusted increases in programs and services. While this theoretically supports wage growth and price stability, it also means that government budgets and deficits grow, potentially outpacing revenue growth. Over decades, the cumulative effect of a 2% increase each year can significantly inflate government spending.
5. Taxpayer Burden: Taxpayers ultimately bear the burden of these inflation-linked increases through higher taxes or increased debt, as the government seeks ways to finance the growing cost of entitlements and interest payments. This could mean higher taxes in the future or reduced spending in other areas to manage deficits, impacting economic growth and public investment.
6. Questioning the 2% Target’s Long-Term Impact: Originally, the 2% target was designed to provide a cushion against deflation, to promote growth and stability. However, this target has led to permanent price increases that may not be necessary and instead contribute to ongoing fiscal stress. In today’s economy, critics suggest that a ZERO inflation target or a lower targeted range may more effectively balance economic growth without continuously inflating costs.

In Summary:

The 2% inflation target that the Fed established in 2012 has created a cycle where federal spending on entitlements, salaries, and debt servicing grows automatically, impacting government budgets and the taxpayer base. While the intention was economic stability, this target has driven up government costs and increased the taxpayer burden. Some experts argue that a ZERO or lower inflation target could lessen these pressures while still achieving the Fed’s goals.

The case for a zero percent inflation policy combined with an interest rate cap, such as 3%, can be made based on the potential economic stability and predictability it might offer, particularly regarding government spending on inflation-adjusted entitlements and programs. Here are a few points in favour of this argument:

1. Reduction in Government Spending Growth: A zero-inflation target would limit the automatic increases in entitlements, pensions, and federal salaries tied to inflation. Since programs like Social Security, Medicare, and various government contracts adjust based on inflation rates, maintaining a zero-inflation policy would potentially stabilize or even reduce government spending over time, easing the tax burden on future generations
2. Enhanced Predictability for Budgeting: With a zero-inflation target, both public and private sectors could plan budgets with greater certainty, knowing that costs will not rise due to inflation. This predictability could also contribute to economic stability by allowing for more consistent spending and investment strategies, without the need to frequently adjust for inflationary impacts.
3. Lower Borrowing Costs: By capping interest rates on credit transactions at 3%, borrowing becomes more affordable and predictable for consumers, businesses, and the government. Lower borrowing costs could stimulate economic activity without fueling inflation, as seen in times of economic expansion under low-interest conditions. This would also make it easier for the government to manage debt repayment without escalating interest expenses.
4. Avoidance of "Inflation Tax": Inflation erodes purchasing power, effectively acting as a hidden tax on savings and incomes. By eliminating inflation, people retain more value in their earnings and savings, promoting individual financial stability and leading to higher consumer confidence and spending.
5. Reduction in Income Inequality: Inflation disproportionately affects lower-income households, which spend a higher percentage of their income on necessities that are subject to price increases. A zero-inflation policy would mitigate some inequality by stabilizing costs for essential goods and services, benefiting all citizens especially those with fewer resources.

However, setting a zero-inflation target and a strict cap on interest rates would require careful management to avoid risks like deflation, which could harm economic growth. Additionally, such policies would significantly shift the Federal Reserve’s traditional mandate and would likely necessitate structural reforms in how monetary policy is conducted. 

The zero inflation and interest rate cap approach, if implemented with sufficient safeguards, could lead to a more stable and predictable economy, potentially reducing government costs over time.