US inflation came in line with expectations in July. The Consumer Price Index, a measure of goods and services across the country, rose 0.2% from June to July, a 2.9% gain from the same period a year ago. Core prices, which exclude the costs of food and energy, were up 0.2% month over month.

The latest data keeps the door open for a September interest rate cut as the Federal Reserve inches closer to its inflation target of 2% over the long run.

Following its most recent policy meeting, Fed Chair Jerome Powell indicated the central bank was “getting closer to the point” of cutting interest rates, although he did not elaborate on how significant that rate cut would likely be.

Why is the target set at 2%?

Inflation data has long been a precursor of Fed policy changes because of the central bank's dual mandate to promote maximum employment and price stability.

While the central bank has never explicitly defined a number for maximum employment, inflation expectations have been anchored to 2% since 2012.

David Wilcox, an economist with the Peterson Institute for International Economics and Bloomberg Economics, said that the 2% target gives the central bank ample room to adjust policy to maintain the health of the economy.

“You want a little bit of a buffer for the Fed to be able to cut interest rates when times are normal so that if the economy tips into recession, there's room for the Fed to take action against it,” Wilcox said. “You want to start out with interest rates high enough above zero so that there's latitude for the Fed to ease conditions, to lower interest rates, to bring mortgage rates down, and borrowing rates for cars.”

Read more: Fed predictions for 2024: What experts say about the possibility of a rate cut

'A revolution' in central bank thinking

The 2% target has been widely adopted by central banks around the world today, but its foundation stems from an off-the-cuff remark made in New Zealand, not an academic research paper.

In 1988, New Zealand was grappling with two decades of double-digit inflation. When the country's Finance Minister, Roger Douglas, was pressed in a television interview on how he planned to bring high prices down, he said he wanted inflation to come down to a range of 0% to 1%. At the time, prices had already begun dipping below 10% for the first time in years.

The comment wasn’t rooted in policy, but it set public expectations. When former Bank of New Zealand Governor Don Brash assumed his post, he pushed to make the idea official, extending the inflation target range to 2% to give policymakers additional space to maneuver.

Central banks in Canada and England soon followed suit. But the Fed didn’t publicly adopt a target until 2012, during Ben Bernanke’s tenure as chairman. At a press conference following the Federal Open Market Committee’s January meeting that year, Bernanke officially announced the 2% inflation goal, saying that it “should help foster price stability and moderate long-term interest rates.”

“There was a time when Fed policymakers attempted to cultivate an aura of mystery and cloak their statements in ambiguity,” Wilcox said. “[Bernanke] was at the forefront of a revolution in thinking that being clear about what your objectives are, communicating crisply and understandably to both financial market participants and to ordinary households and businesses about exactly what you're doing and why you're doing it, that promotes the objectives of monetary policy. It helps monetary policy be more effective.”

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In the ensuing years, inflation consistently tracked below the 2% target. In 2020, the Fed tweaked its policy following a review of its monetary policy framework to allow for further flexibility, and Fed officials sought to achieve inflation that averages 2% over time through a policy known as “average inflation targeting.”

Stubborn inflation since the pandemic has reignited the debate over the Fed’s inflation policy.

Critics contend that the target number should be higher than 2%. At a House Financial Services Committee hearing earlier this year, Congressman Brad Sherman, a Democrat from California, questioned Powell on whether the Fed’s inflation policy was sufficient enough to maintain the health of the economy.

"If the standards are too high, we lose economic growth," he said. "If they’re too low, we have bailouts and bankruptcies."

Other critics have argued that the Fed's hyperfocus on inflation comes at the expense of the labor market and that the Fed should adopt a similar numerical target for its other mandate.

The Fed reviews its monetary policy framework every five years. With the latest review set to begin this year, officials have vowed to “thoroughly” examine its “policy strategy, tools, and communication practices.”

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