In today’s Finshots, we tell you about the silent, yet most important, change in the US Fed’s stance.

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The Story

2%.

It looks like just a number. But for the last three decades, this has been one of the most important digits in global finance. It’s where the Federal Reserve — the world’s most powerful central bank — wants US inflation to sit.

Why 2% though? Honestly, there’s nothing divine about it. The premise was rather whimsical. Back in the early 1990s, New Zealand wanted to tame runaway inflation and picked 2% as a neat, low-enough, believable goal. It worked. So other central banks copied it, and by 2012 the Fed made it official. Economists liked it because it was high enough to avoid the nightmare of deflation, but low enough that people wouldn’t notice prices creeping up. So you can say it was a number pulled from a magic hat… but a hat everyone agreed to wear.

But regardless of that fact, that number has caused chaos. A lot of chaos. For instance, if US inflation is high, the Fed raises rates. That makes the dollar stronger. And money leaves emerging markets to chase dollar returns. And all of this means asset prices swing and debt becomes costlier. If inflation falls, the opposite happens. So that little “2%” decides whether billions flow into India or out of it.

Here’s the catch though. The Fed hasn’t been able to hit that 2% target consistently for nearly 50 months now. In fact, in the 2010s, it struggled with too little inflation. Post-COVID, it got the opposite, with the highest inflation in 40 years!

So the Fed tried something clever in 2021: a new framework called “flexible average inflation targeting” (FAIT). Basically, the central bank would allow inflation to stay above 2% for a while to make up for the times it had been below 2%, balancing things out.

And while that sounded neat in theory, reality had other plans. Inflation didn’t gently climb above 2%. It shot up to as high as 8%!! As one paper by the Fed puts it… “we document that U.S. inflation rose post-FAIT considerably more than predicted had the strategy not changed”.

So yeah, the Fed’s “overshoot” policy looked less like prudence and more like pouring gasoline on a fire.

If you track US markets, you probably already know this bit.

But the reason we write this story today is that Fed officials met a few days back and made a small tweak to the line around that 2%.

It now says, “The Committee is prepared to act forcefully to ensure that longer-term inflation expectations remain well anchored.”

To put it simply, it abandoned its 2020 idea that averaging inflation when it stays above the target can be useful. And also quietly brought back flexible inflation targeting. 

Okay, but if the Fed still believes in 2%, why does this change matter, you ask? After all, it’s just the word ‘average’ that’s disappeared.

You’re not wrong to think that but hear us out.

In practice, this means the Fed won’t simply “forgive” inflation if it lingers above the 2% target. But that doesn’t automatically translate into keeping interest rates painfully high forever. The Fed chair, Jerome Powell, has already hinted that the “neutral rate” of interest or the level where policy is neither too tight nor too loose, may be higher now than it was in the 2010s.

To put it simply, the Fed could still cut rates even if inflation sits at, say, 2.6%, as long as it’s on a downward path and the job market looks shaky. And when that happens, you’ll hear the Fed point to the labour market as the reason — insisting they’re cutting to protect a weakening outlook.

But here’s the bigger picture. This whole debate is less about the actual inflation number and more about the Fed’s credibility. Everyone knows that 2% is arbitrary. The real power lies in psychology. As long as people believe in 2%, wages and prices remain anchored. But let that belief slip, and expectations could spiral. That’s why Powell has to publicly swear loyalty to the 2% target, even as he quietly bends the rules in practice.

Okay, so why does this matter for markets?

Because the whole game changes. If you were betting on a crash, expecting the Fed to keep strangling growth until inflation was exactly 2%, you may be in for a surprise. The new regime suggests shallower cycles. And that means more rate cuts than anticipated.

And there’s another unspoken factor — the US debt that’s standing at $34 trillion. So every 1% rise in interest rates adds hundreds of billions of dollars to the US government’s interest bill. So cutting before inflation hits exactly 2% isn’t just about jobs. It’s also about managing that debt pile.

So the bottom line is that the Fed will cut rates at a time when asset prices are high. And that will mean more liquidity in the market coming from US national debt and money printing. And investors are going to hunt for returns.

Sure, in theory that debt mountain could topple markets. But history shows that liquidity often pushes asset prices up before any reckoning arrives. More cuts means more money and more money means more investors chasing stocks, bonds and everything in between.

That’s why maybe, just maybe, the people betting big on a correction could be on the wrong side of this cycle. But as we said, the markets have a knack for surprises, and we’re no experts, so we’ll just have to wait and watch.

The simple takeaway is that central banks rarely change their words by accident. If you listen closely, the cues are hidden in the edits.

And this matters for India too. Global flows chase these signals. When the Fed loosens, FIIs pour into Indian equities, valuations stretch, and the rupee steadies. Exporters like IT and pharma get a tailwind from a resilient US economy. And the RBI with its 4% inflation target will also take notes.

So yeah, the 2% number survives, but now the Fed wants to interpret it more flexibly, depending on the labour data. And for investors waiting for a crash, the bigger risk may be that this cycle stretches longer than expected; with liquidity fuelling markets while everyone waits for the other shoe to drop.

Until then…

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