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Understanding Inflation Targeting
If you follow the financial market, you've possibly heard about Inflation Targeting. It's a fascinating way in which governments try to keep economic growth on a stable trajectory and here you will find all the information you need to understand what inflation targeting is, how it works and why it matters.
What is Inflation Targeting?
Inflation targeting is a policy that central banks use to adjust monetary policy to achieve a specific annual rate of inflation. The final goal of inflation targeting is achieving long-term economic growth and stability by maintaining price stability, which is something that you do when you control inflation.
Basically, the central bank sets an inflation rate as a target and adjusts monetary policy to achieve that rate. They do that by using tools like interest rate changes or through managing their balance sheet by buying/selling bonds. Alternative policy goals of central banks include targeting national income, exchange rates, or unemployment.
Understanding Inflation Targeting
When following an inflation targeting strategy, the primary target of the central bank is to keep prices stable. The way it works is quite straightforward. Essentially, the Central Bank forecasts the future path of inflation and compares it with the target inflation rate. Then, the difference determines how much monetary policy must be adjusted so that the inflation target is achieved. For example, the central bank may raise or lower interest rates depending on whether it thinks inflation will be above or below the target threshold in the future (for example in 2-years time as monetary policy has a lag).
The benchmark used for inflation targeting is typically a price index of a basket of consumer goods like the Personal Consumption Expenditures Price index that the US Federal reserve uses or Harmonized Consumer Price Index that the European Central Bank uses.
Most countries that have inflation targeting mandates set their targets in the low single digits. The approach is not to always achieve it, but rather achieving it over the medium term – which typically is over two or three years. That allows monetary policy makers to address other objectives over the short term, removing the need to do whatever it takes to meet targets on a period-by-period basis.
US & UK Inflation Targeting
Both the US and the UK are countries where the government sets targets for inflation. However, the first country in the world to adopt inflation targeting was New Zealand, and then other countries like Finland, Spain, Canada, Sweden, and Czech Republic followed suit. The UK adopted inflation targeting in 1992.
US Inflation targeting was only adopted as a mandate in a historic shift on 25 January 2012, when the US Federal Reserve Chairman – Ben Bernanke – set a 2% target inflation rate[MOU1] . That brought the country in line with many of the world's other major central banks. Before that, the FOMC[MOU2] regularly announced a desired target range for inflation – which was usually between 1.7% and 2% - measured by the personal consumption expenditures price index.
The UK government sets an inflation target of 2% CPI for the Bank of England[MOU3] . If the Bank misses that target by more than 1 per cent either side of the target, then the Governor must write a letter to the Chancellor to explain why, before working out a plan to get it back to 2%. The inflation letters that the Governor of the Bank of England sends to the Chancellor of the Exchequer are publicly available[MOU4] .
Pros and Cons of Inflation Targeting
Inflation Targeting has defenders and detractors. And here we will list for you the pros and cons of Inflation Targeting, so you understand in which ways it is useful and in which ways there could be better alternatives to encourage growth in markets.
Inflation targeting pros:
- It allows central banks to respond to shocks to the domestic economy and focus on domestic considerations.
- Stable inflation reduces investor uncertainty
- Stable inflation allows investors to predict changes in interest rates
- Stable inflation anchors inflation expectations
- It allows for greater transparency in monetary policy if the target is published.
- Avoid "boom and bust' economic cycles where the economy goes through periods of high inflationary growth that are unsustainable and lead to recessions.
Inflation targeting cons:
- Some market analysts believe that inflation targeting creates the right environment for unsustainable speculative bubbles to thrive unchecked (like it happened in the 2008 financial crisis).
- Others believe that it encourages inadequate responses of terms-of-trade shock or supply shocks.
- It may lead to the Central Banks to start ignoring more pressing problems like the costs of rising unemployment.
- Inflation targets are limited
- Some critics think that exchange rate targeting, or nominal GDP is better for creating economic stability[MOU5] . A fixed exchange rate gives a central bank little way of controlling domestic inflation for example.
What is inflation targeting mandate?
An Inflation Targeting Mandate is when a central bank follows an explicit target for the inflation rate for the medium-term and announces this inflation target to the public. Central banks pursue inflation targeting because they assume that it will lead to long-term growth of the economy by maintaining price stability, something which is achieved by controlling inflation.
What is meant by inflation targeting?
To keep it short and sweet, inflation targeting is a central bank strategy that specifies the inflation rate as a goal and adjusts monetary policy accordingly to achieve that rate in the medium-term. The focus is to maintain prices at a stable level because there is a belief that it supports economic growth and stability.
How do inflation targets work?
Inflation targeting is a monetary policy that can be a key factor in boosting the economy. It is where the central bank sets a specific inflation rate as its goal to keep the economy stable. Most central banks set up inflation target around 2-3%[MOU6] . They do that to encourage economic growth in a sustainable and stable way.
The rationale is that when prices fall, people put off buying cars, houses, and other big-ticket items if they think prices can still get lower later. If prices rise too fast, inflation can spiral out of control and people and businesses lose confidence in the value of money. However, if they think prices will go up in a slow and steady manner, they are more likely to have the confidence to commit to big purchases. This generally helps foster more stable economic growth.
Why does the government set an inflation target?
As voiced by the Bank of England and the Federal Reserve, governments that do inflation targeting set inflation targets to keep inflation low and stable. They do that in the belief that it helps people plan and it leads to economic growth.
The Bank of England, for example, explains that "if inflation is too high or it moves around a lot, it's hard for businesses to set the right prices and for people to plan their spending.". On the other hand, "if inflation is too low, or negative, then some people may be put off spending because they expect prices to fall". And "if everybody reduced their spending, then companies could fail, and people would lose their jobs".
We hope that after reading this guide you will have a much better understanding about inflation targeting. But if you do still have any questions, we are here to help. As always, check out the rest of our guides or browse some of the latest market news.
[MOU2]Link to FOMC page
[MOU6]Sources: https://www.federalreserve.gov/faqs/what-economic-goals-does-federal-reserve-seek-to-achieve-through-monetary-policy.htm and https://www.brookings.edu/research/alternatives-to-the-feds-2-percent-inflation-target/
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