Inflation targeting

What Is Inflation Targeting?

Inflation targeting is a monetary policy framework in which a central bank publicly commits to achieving a specific annual inflation rate or range. This approach, falling under the broader category of monetary policy, aims to maintain price stability and can foster sustainable economic growth. By setting a clear target, inflation targeting provides a transparent guide for monetary policy decisions, helping to anchor inflation expectations among businesses and consumers. Central banks using inflation targeting adjust interest rates and other tools to steer inflation towards the stated goal.

History and Origin

The concept of inflation targeting gained prominence in the early 1990s as several central banks sought a more effective framework following periods of high inflation. New Zealand was the pioneer, formally adopting inflation targeting in 1990. Other countries, including Canada, the United Kingdom, and Australia, soon followed suit. For instance, the Reserve Bank of Australia (RBA) maintains an annual consumer price inflation target of 2 to 3 percent, a range agreed upon with the Australian Government.¹⁶ The framework emerged from a desire to move away from earlier monetary policy strategies, such as strict money supply targeting or discretionary approaches, which had proven less effective in achieving price stability.

In the United States, the Federal Reserve did not formally adopt an explicit numerical inflation target until 2012, when the Federal Open Market Committee (FOMC) publicly committed to a 2 percent inflation target for the Personal Consumption Expenditures (PCE) price index.¹⁴, ¹⁵ This decision came after decades of deliberation and a shift in consensus following the 2008 financial crisis, during which many FOMC participants had preferred a lower target.¹², ¹³ The formal adoption of inflation targeting by major central banks underscored a global shift towards greater transparency and accountability in monetary policy.

Key Takeaways

• Inflation targeting is a monetary policy strategy where a central bank aims for a specific inflation rate or range.
• It enhances transparency and accountability in monetary policy.
• This framework helps anchor inflation expectations, contributing to price stability.
• Central banks adjust tools like interest rates to achieve the stated inflation target.
• Inflation targeting seeks to balance price stability with other objectives, such as maximum employment.

Interpreting Inflation Targeting

Interpreting inflation targeting involves understanding a central bank's commitment to its stated goal and how it reacts to deviations. When a central bank publicly announces an inflation target, it signals its primary objective for price levels. For example, if the target is 2%, the central bank will typically implement policies to bring inflation back to this level if it deviates significantly, whether too high or too low. This commitment helps shape public and market expectations, making future inflation more predictable. The Reserve Bank of Australia (RBA), for instance, aims to keep annual consumer price inflation between 2 and 3 percent.¹¹ Monitoring the actual inflation rate against the target is crucial for assessing the effectiveness of monetary policy and forecasting future economic conditions.⁹, ¹⁰

Hypothetical Example

Consider a hypothetical country, "Econoland," where the central bank has adopted an inflation targeting framework with a target of 2.5% annual inflation. In a given year, Econoland experiences unexpected supply chain disruptions, leading to a surge in commodity prices and pushing inflation up to 4.5%.

The central bank, observing this deviation from its 2.5% inflation target, would likely respond by tightening its monetary policy stance. This could involve raising the benchmark interest rates, making borrowing more expensive, and thereby cooling down aggregate demand. The central bank might also communicate its commitment to bringing inflation back to target, providing forward guidance to manage public expectations. As a result of these actions, economic activity might slow, and inflationary pressures would gradually subside, bringing inflation back towards the 2.5% target over a reasonable period.

Practical Applications

Inflation targeting is a cornerstone of modern central banking and has numerous practical applications in economic management. Central banks around the world use this framework to guide their policy decisions, influencing everything from lending rates to long-term investment planning.

One key application is in maintaining price stability, which is considered a prerequisite for sustained economic growth. By targeting a low and stable inflation rate, central banks aim to prevent the erosion of purchasing power and reduce uncertainty for businesses and households. For instance, the Federal Reserve's commitment to a 2 percent inflation target helps anchor longer-term inflation expectations, which is vital for investment and consumption decisions.⁸

Inflation targeting also provides a clear nominal anchor for the economy, allowing market participants to make more informed decisions about wages, pricing, and contracts. It can also enhance central bank accountability, as the public can monitor whether the central bank is achieving its stated objective. The International Monetary Fund (IMF) projects global headline inflation to decline, but notes that inflation may remain above target in some economies, highlighting the ongoing relevance of inflation targeting frameworks in addressing current economic challenges.⁵, ⁶, ⁷

Limitations and Criticisms

Despite its widespread adoption, inflation targeting faces several limitations and criticisms. One common critique is that it can lead to a central bank focusing too narrowly on inflation, potentially at the expense of other important economic objectives like unemployment or financial stability. Critics argue that rigid adherence to an inflation target might prompt a central bank to tighten policy during a recession to curb inflation, thereby exacerbating the economic downturn. The legacy of a high inflation history can also influence the conduct of monetary policy, leading some inflation-targeting countries to respond more aggressively to deviations from the target.⁴

Another limitation can arise during periods when the effective lower bound on interest rates is reached, meaning interest rates cannot be cut further to stimulate the economy. In such scenarios, conventional inflation targeting might become less effective, necessitating the use of unconventional monetary policy tools like quantitative easing or strong forward guidance. Some researchers have also pointed out that changes in economic conditions, such as a decline in the natural rate of interest, can make it harder for central banks to achieve their inflation targets through traditional means.³ Furthermore, there is debate whether inflation targeting alone can address all forms of economic shocks, particularly supply-side shocks, without unintended consequences.

Inflation Targeting vs. Quantity Theory of Money

Inflation targeting and the quantity theory of money represent distinct, though sometimes complementary, approaches to understanding and managing price levels.

While inflation targeting focuses on influencing inflation expectations and managing aggregate demand through interest rate adjustments, the quantity theory of money posits a direct relationship between the amount of money in circulation and the price level. Under the quantity theory of money, controlling the money supply is seen as the primary lever for controlling inflation. In contrast, inflation targeting allows for more flexibility in the tools used, adapting to various economic conditions to meet the stated inflation goal, rather than strictly adhering to a monetary rule.

FAQs

What is the typical inflation target for most developed economies?

Most developed economies, including the United States, the Euro Area, and the United Kingdom, typically aim for an inflation target of around 2% annually. This rate is generally considered low enough to avoid the distortions of high inflation but high enough to provide a buffer against deflation and allow for sufficient economic growth.

How does inflation targeting impact individuals?

Inflation targeting aims to provide price stability, which benefits individuals by preserving the purchasing power of their money over time. It reduces uncertainty about future prices, making it easier for individuals to plan for spending, saving, and investing. Stable prices can also lead to more predictable interest rates on loans and savings.

Can inflation targeting prevent recessions?

While inflation targeting aims for price stability and can contribute to sustainable economic growth, it is not designed to prevent recessions entirely. Economic downturns can be caused by various factors, including supply shocks, financial crises, or declines in aggregate demand. However, a credible inflation targeting framework can provide the central bank with flexibility to respond to economic shocks while maintaining its long-term commitment to price stability.

What happens if a central bank misses its inflation target?

If a central bank consistently misses its inflation target, either by having inflation too high or too low, its credibility may be challenged. In such cases, the central bank might need to adjust its monetary policy tools more aggressively or provide clearer forward guidance on its strategy to bring inflation back to target. For example, after periods of persistently low inflation, some central banks, like the Federal Reserve, have indicated they may aim for inflation moderately above their 2 percent target for some time to ensure the average inflation rate over time is 2 percent.¹, ²