Policy implications

What Is Inflation Targeting?

Inflation targeting is a monetary policy strategy where a central bank publicly announces a specific, long-term target inflation rate and then uses its policy tools to steer actual inflation toward that target. This approach falls under the broader umbrella of monetary policy and is primarily aimed at achieving price stability, which is considered conducive to sustainable economic growth. By providing a clear objective for inflation, central banks aim to anchor inflation expectations, thereby influencing economic decisions made by households and businesses. Inflation targeting often involves managing interest rates as the primary instrument to achieve the desired inflation rate.

History and Origin

The concept of inflation targeting gained prominence in the early 1990s, emerging as a response to the challenges central banks faced in managing inflation following the collapse of the Bretton Woods system and the instability of monetary aggregates. Countries like New Zealand (1990), Canada (1991), and the United Kingdom (1992) were among the first to adopt formal inflation targeting frameworks.

In the United States, while the Federal Reserve implicitly pursued price stability, an explicit numerical inflation target was not formally adopted until 2012. Prior to this, the U.S. experienced periods of high inflation, notably the "Great Inflation" from the mid-1960s to 1982, where inflation reached over 14% in 1980¹¹. Paul Volcker, who became Chairman of the Federal Reserve in 1979, implemented aggressive monetary policy actions, known as the "Volcker disinflation," raising the federal funds rate to unprecedented levels to combat rampant inflation. This period, while leading to a severe recession and high unemployment, successfully brought inflation down significantly and helped restore the Federal Reserve's credibility⁸, ⁹, ¹⁰. The Federal Reserve's formal adoption of a 2 percent inflation target in 2012 marked a significant step toward greater transparency and clarity in its long-run goals, building on decades of internal deliberation⁶, ⁷.

Key Takeaways

• Inflation targeting is a monetary policy strategy where a central bank sets a specific, public target for the inflation rate.
• Its primary goal is to achieve and maintain price stability, fostering a stable economic environment.
• Central banks typically use short-term interest rates as their main tool to influence inflation toward the target.
• A key benefit is enhanced transparency and accountability, which can help anchor inflation expectations.
• The Federal Reserve officially adopted a 2 percent inflation target in 2012, as measured by the Personal Consumption Expenditures (PCE) price index.⁵

Interpreting Inflation Targeting

Interpreting inflation targeting involves understanding how a central bank's actions are guided by its announced inflation objective. When inflation is above the target, the central bank is typically expected to implement tighter monetary policy, often by raising interest rates, to cool down the economy and bring inflation back to target. Conversely, if inflation falls below the target, especially persistently, the central bank might pursue more accommodative policies, such as lowering interest rates, to stimulate economic growth and encourage inflation to rise.

The Federal Reserve, for instance, targets a 2 percent inflation rate over the longer run, using the annual change in the Personal Consumption Expenditures (PCE) price index as its primary measure⁴. This 2% target is widely considered optimal for a healthy, stable economy, balancing the risks of deflation with the costs of high inflation.

Hypothetical Example

Consider a hypothetical country, "Econoland," whose central bank has an explicit inflation target of 2%. In a given year, due to strong consumer demand and rising wages, the inflation rate, as measured by the Consumer Price Index, rises to 4%.

The central bank's policy committee observes this upward deviation from its 2% target. To address this, it decides to implement a tighter monetary policy. This involves:

1. Raising the policy interest rate: The central bank increases the benchmark interest rate, making it more expensive for commercial banks to borrow money.
2. Impact on lending: Commercial banks, in turn, raise their lending rates for consumers and businesses.
3. Reduced spending and investment: Higher borrowing costs discourage consumer spending on large purchases (like homes and cars) and reduce business investment, thereby slowing down overall economic activity.
4. Inflation moderation: As demand in the economy cools, the upward pressure on prices diminishes, helping to bring the inflation rate back down toward the 2% target.

This proactive adjustment, driven by the inflation target, helps prevent inflation from becoming entrenched and ensures long-term price stability.

Practical Applications

Inflation targeting is a widely adopted framework by central banks globally, guiding their monetary policy decisions. Its practical applications are evident in:

• Policy Formulation: Central banks explicitly integrate the inflation target into their policy deliberations, influencing decisions on benchmark interest rates, quantitative easing, and other monetary tools.
• Communication Strategy: Central banks use the inflation target to communicate their objectives and future policy intentions to the public, markets, and governments. This transparency enhances the predictability of monetary policy actions. The Federal Reserve, for example, clearly states its long-run inflation goal of 2 percent, which "facilitates well-informed decisionmaking by households and businesses, reduces economic and financial uncertainty, increases the effectiveness of monetary policy, and enhances transparency and accountability".
• Accountability: The explicit target provides a benchmark against which the central bank's performance can be evaluated, promoting greater accountability in its pursuit of price stability.
• Inflation Expectations Management: By clearly stating the target, central banks aim to anchor public and market inflation expectations. If individuals and businesses expect inflation to remain stable around the target, their wage and pricing decisions are less likely to fuel inflationary spirals.
• International Coordination: While each central bank operates independently, the widespread adoption of similar inflation targets (often around 2%) facilitates a degree of implicit coordination and understanding in global financial markets.

Limitations and Criticisms

Despite its widespread adoption, inflation targeting faces several limitations and criticisms:

• Focus on Price Stability over Other Goals: Critics argue that a strict adherence to an inflation target might lead central banks to neglect other important macroeconomic objectives, such as maximizing employment or ensuring financial stability. For example, some suggest that inflation targeting can struggle to deal with large supply and demand shocks and may contribute to financial instability³. While many central banks operate under a dual mandate (e.g., price stability and maximum employment, like the Federal Reserve), a rigid focus on inflation can sometimes lead to policy choices that might have adverse short-term impacts on the output gap or unemployment.
• The Zero Lower Bound: In periods of very low inflation or deflationary pressures, central banks may find it difficult to stimulate the economy by cutting interest rates further once rates hit or approach zero. This "effective lower bound" can limit the effectiveness of inflation targeting, as conventional tools become less potent.
• Ignoring Asset Price Bubbles: A narrow focus on consumer price inflation might cause central banks to overlook the buildup of imbalances in asset markets, potentially leading to financial bubbles that could eventually burst and trigger a recession.
• Lagged Effects of Policy: Monetary policy actions often have long and variable lags before their full effects are felt in the economy. This makes it challenging for central banks to precisely calibrate their actions to hit a specific inflation target at a specific time.
• "Sacrifice Ratio" Concerns: Some academic work suggests that inflation-targeting central banks may not necessarily achieve lower output and employment losses when combating inflation compared to countries without such a strategy². The costs associated with bringing down high inflation, such as increased unemployment and reduced economic growth, are often termed the "sacrifice ratio."

Inflation Targeting vs. Monetary Policy

While often discussed interchangeably in casual conversation, inflation targeting and monetary policy are distinct but related concepts.

In essence, inflation targeting is a particular way a central bank chooses to conduct its monetary policy to achieve certain economic goals, primarily price stability. Not all monetary policies involve explicit inflation targets, but most central banks today, including the Federal Reserve, use some form of inflation targeting or a flexible interpretation of it.

FAQs

What is the Federal Reserve's inflation target?

The Federal Reserve aims for an inflation rate of 2 percent over the longer run, as measured by the annual change in the Personal Consumption Expenditures (PCE) price index. This target is part of its dual mandate, which also includes promoting maximum employment.¹

Why do central banks target 2% inflation?

A 2% inflation target is widely considered optimal because it provides a buffer against deflation (a harmful fall in prices), allows for necessary relative price adjustments in the economy, and gives central banks room to lower interest rates during economic downturns without hitting the zero lower bound. It is seen as a rate that promotes price stability without hindering economic growth.

Does inflation targeting prevent recessions?

No, inflation targeting does not prevent recessions. While it aims to stabilize prices and foster a healthy economic environment, economies can still experience downturns due to various factors like financial crises, supply shocks, or shifts in consumer demand. In some cases, aggressive monetary policy undertaken to achieve the inflation target might even contribute to a temporary slowdown or recession.

Is inflation targeting the only monetary policy strategy?

No, inflation targeting is one of several monetary policy strategies. Historically, central banks have used other frameworks, such as targeting monetary aggregates (controlling the growth of the money supply), fixed exchange rates, or simply discretionary policy without a formal public target. However, inflation targeting has become the dominant framework for many developed and emerging economies due to its benefits in transparency and credibility.