Fed's 2% Inflation Target May Cause Instability, Austrian Critique Says

The Federal Reserve's commitment to 2% inflation faces a long-standing challenge from Austrian-school economists who argue that the very policy of price stability sets the stage for the next bust. The critique, drawn from the work of Murray Rothbard, points to the 1920s as a warning. Wholesale prices were stable through that decade. The money supply was not.

Wholesale prices stood at 93.4 in June 1921 (1926=100), rose to 104.5 by November 1925, then fell back to 95.2 by June 1929. Over that same period, the money supply increased by $28 billion, a 61.8% jump. Average annual growth hit 7.7%. “The fact that general prices were more or less stable during the 1920s told most economists that there was no inflationary threat, and therefore the events of the great depression caught them completely unaware,” Rothbard wrote.

The logic of the critique is straightforward. The Fed targets the price level. To hit that target, it adjusts the money supply and interest rates. New money does not enter the economy evenly. It flows to specific borrowers first, altering relative prices and redirecting resources into malinvestments. A stable price level masks these shifts. Businesses see stable headline numbers but miss the distortions in the structure of production.

William J. McDonough, former President of the Federal Reserve Bank of New York, articulated the standard view: “Over the long run, price stability is the one sustainable contribution monetary policy can make to growth.” The Austrian rebuttal holds that the policy of achieving price stability through monetary manipulation is itself a source of instability.

Rothbard also challenged the very idea of measuring a “general price level.” He noted that purchasing power is specific to each good at a given time and place. “Since the general exchange-value, or PPM, of money cannot be quantitatively defined and isolated in any historical situation, and its changes cannot be defined or measured, it is obvious that it cannot be kept stable,” he wrote. “If we do not know what something is, we cannot very well act to keep it constant.”

Today’s Fed targets 2% inflation using the PCE index. The Austrian critique argues that this focus on a single number repeats the error of the 1920s. The policy of stabilizing the price level interferes with the market’s signals, falsifying relative prices and undermining the wealth-generation process. The policy of attaining price stability leads to economic instability.

The analysis does not predict a near-term crisis. It warns that the Fed’s toolkit, including interest rate targets and money supply management, is inherently destabilizing over time. The 1920s example stands as a reminder: price stability is not economic stability.