The Federal Reserve aims for 2% inflation of personal consumption expenditures over the long term. Why 2%? The Fed argues ‘when households and business can reasonably expect inflation to remain low and stable, they are able to make sound decisions regarding saving, borrowing, and investment, which contribute to a well-functioning economy.’
In reality, major central banks latched onto 2%, but that figure is hardly scientific. A stable rate of inflation at 3% would still be low and economic agents would be able to make sound decisions. As many analysts note, a 3% target could provide more room above the zero low bound, provide nominal ‘grease’ for the economy and better offset any downward inflation measurement bias.
The Fed’s framework review earlier this year entrenched the 2% target. Many analysts reasonably suggested that had the Fed switched from 2% to 3%, its credibility would have been compromised, particularly in the wake of the pandemic inflation spike.
But could the Fed stealthily and unintentionally end up near 3%? Even apart from above-target inflation in recent years, short- and longer-term structural forces are at play that could usher in slightly higher inflation, notwithstanding Fed speeches on the sanctity of the 2% inflation target. Consumer surveys suggest inflation may be anchored, but around 3%.
Tariffs and dollar depreciation are two shorter-term factors
Economists predict US tariffs will boost inflation, certainly in the short term, though magnitudes and pass-through are debated. Some forecasts suggest inflation could reach around 3.5% by year-end and remain around 3% in the first half of 2026. The Yale Budget Lab estimated a baseline scenario in which current tariff levels push prices 1.7% higher.
A key question is whether the tariff hit to inflation will be one-off and should be looked through. That is a reasonable argument. But it is also possible that higher tariff-induced inflation could generate some second-round pressures.
The dollar has been extremely strong in recent years, but depreciated by some 6% on a trade-weighted basis and 11% versus the DXY so far in 2025. While predicting exchange rates is a fool’s errand, there is scope for further depreciation, especially with prospective Fed rate cuts and global concerns about US economic and foreign policy. A 10% trade-weighted depreciation could translate into a 0.3 percentage point rise in inflation.
Immigration, fiscal dominance, geopolitics and fragmentation are longer-term forces
The Donald Trump administration’s immigrant crackdown is cutting the supply of labour. In past years, breakeven monthly payroll jobs growth consistent with full employment was estimated around 150,000, whereas now it is put in the range of 30,000-80,000. A lower labour supply may push up wages, especially in construction, agriculture, hospitality and services – and reduce housing supply.
This could be compounded by demographic trends, especially if ageing reduces supply more than demand.
US debt held by the public is now roughly 100% of gross domestic product. It is headed higher over the next 10 years, perhaps towards 130%, notwithstanding increased tariff revenues, amid massive deficits perhaps around 6% of GDP per annum. Bond markets may have difficulties digesting such issuance volumes, propping up longer-term yields, which do not necessarily respond to movements in short-term official rates. The US is hardly alone in being boxed in by modest growth, a reluctance to raise taxes and a lack of political will to cut spending.
Pressure on central bank independence
Research shows that ‘independent’ central banks are better able to achieve inflation goals. Notwithstanding strong support for central bank independence, high debt and deficits are a potential recipe for fiscal dominance and financial repression.
Politicians may well exert pressure on central banks to provide cheap finance for Treasuries, keeping interest rates below nominal growth rates. Trump argued the Fed Funds rate should be at 1% to reduce the government’s interest bill. Such policies could lift underlying inflation and in some politicians’ minds have the added benefit of eroding debt burdens.
Earlier this decade, the movement of Chinese labour from rural areas to cities acted as a global supply shock, facilitating the Great Moderation. Now, apart from tariffs, US-China tensions are contributing to fragmentation of the global trading system.
The International Monetary Fund has estimated that a move towards blocs could cause up to a 7% loss in global GDP. Prior to the pandemic, global supply chains – heavily reliant on China – were priced to perfection. The pandemic and US-China tensions underscored the need for more robust and resilient supply chains, spawning a search for friend- or re-shoring. These forces may raise production costs.
So could recourse to greater use of industrial policy, especially in the US, even if governments have legitimate needs to pursue economic statecraft or tackle market failures. Industrial policies are often associated with cronyism, an inability to pick winners from losers and protectionism.
Inflation may well return to the Fed’s 2% target in the coming years. Falling demand and perhaps higher artificial intelligence-induced productivity could help. But the standard assumption of mean reversion back to target could prove flawed. Structural forces for a slightly higher inflation regime abound.
Mark Sobel is US Chair of OMFIF.
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