4.3 Inflation targeting

Inflation targeting is a monetary policy framework where central banks set explicit inflation rate targets as their primary goal. This approach aims to maintain price stability, anchor inflation expectations, and support sustainable economic growth by adjusting monetary policy tools to steer actual inflation towards the target rate.

Key features of inflation targeting include public announcement of numerical targets, institutional commitment to price stability, and increased transparency. Central bank independence, clear communication, and accountability mechanisms are crucial for successful implementation. Challenges include accurate inflation measurement, managing policy transmission lags, and anchoring inflation expectations effectively.

Inflation targeting fundamentals

Definition of inflation targeting

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• Monetary policy framework that sets an explicit inflation rate target as the primary goal
• Central banks adjust monetary policy tools to steer actual inflation towards the target rate
• Aims to anchor inflation expectations and maintain price stability

Goals of inflation targeting

• Achieve and maintain a low and stable inflation rate over the medium term
• Provide a nominal anchor for monetary policy and inflation expectations
• Promote transparency, accountability, and credibility of the central bank
• Support sustainable economic growth and financial stability

Key features of inflation targeting

• Public announcement of a numerical inflation target or target range
• Institutional commitment to price stability as the primary objective of monetary policy
• Forward-looking and proactive monetary policy decision-making
• Increased transparency through regular communication with the public
• Accountability of the central bank for meeting the inflation target

Implementing inflation targeting

Central bank independence

• Operational independence from political interference in setting monetary policy
• Allows central banks to focus on long-term price stability without short-term political pressures
• Legal mandate and institutional framework to support independence (e.g., fixed terms for governors)

Transparency in monetary policy

• Regular publication of inflation reports, forecasts, and policy decisions
• Clear communication of the central bank's assessment of economic conditions and policy rationale
• Helps manage inflation expectations and enhances the effectiveness of monetary policy
• Increases public understanding and trust in the central bank's actions

Accountability of central banks

• Mechanisms to hold central banks accountable for meeting the inflation target
• Regular testimonies and reports to the government or parliament
• Explanation of deviations from the target and corrective actions taken
• Helps maintain credibility and public support for the inflation targeting framework

Inflation targeting vs other frameworks

Inflation targeting vs price level targeting

• Inflation targeting aims to achieve a specific inflation rate, while price level targeting aims to maintain a specific price level over time
• Price level targeting requires correcting past deviations from the target, potentially leading to more aggressive policy actions
• Inflation targeting allows for some flexibility in accommodating temporary shocks to inflation

Inflation targeting vs monetary targeting

• Monetary targeting focuses on controlling the growth rate of a monetary aggregate (e.g., money supply) to achieve price stability
• Inflation targeting directly targets the inflation rate, which is more closely related to the ultimate goal of price stability
• Monetary targeting can be less effective when the relationship between money supply and inflation is unstable

Inflation targeting vs exchange rate targeting

• Exchange rate targeting involves fixing the value of the domestic currency to a foreign currency or a basket of currencies
• Inflation targeting allows for a flexible exchange rate, which can help absorb external shocks and maintain domestic economic stability
• Exchange rate targeting can be vulnerable to speculative attacks and loss of independent monetary policy

Challenges of inflation targeting

Measuring inflation accurately

• Choosing an appropriate price index that reflects the cost of living and economic conditions
• Accounting for quality changes, new products, and substitution effects in the price index
• Ensuring the timeliness and reliability of inflation data for effective policy decisions

Transmission lags in monetary policy

• Monetary policy actions take time to affect inflation and the real economy (typically 12-18 months)
• Policymakers need to make decisions based on forecasts and expectations of future inflation
• Requires a forward-looking approach and effective communication to manage expectations

Inflation expectations management

• Anchoring inflation expectations is crucial for the success of inflation targeting
• Requires clear communication and credibility of the central bank's commitment to the inflation target
• Inflation expectations can be influenced by various factors, including past inflation, economic shocks, and policy credibility
• Managing expectations can be challenging during periods of economic uncertainty or structural changes

Inflation targeting in practice

Inflation targeting adoption worldwide

• First adopted by New Zealand in 1990, followed by Canada, the United Kingdom, and other advanced economies
• Increasingly adopted by emerging market economies (e.g., Brazil, Chile, Mexico) since the late 1990s
• As of 2021, over 40 countries have adopted inflation targeting as their monetary policy framework

Case studies of successful implementation

• Canada: Adopted inflation targeting in 1991, successfully anchored inflation expectations and maintained price stability
• Chile: Adopted inflation targeting in 1999, gradually reduced inflation from double digits to the target range of 2-4%
• United Kingdom: Adopted inflation targeting in 1992, established credibility and independence of the Bank of England

Lessons learned from inflation targeting

• Importance of institutional reforms and central bank independence for successful implementation
• Need for effective communication and transparency to manage inflation expectations
• Flexibility to accommodate temporary shocks while maintaining long-term price stability
• Importance of considering financial stability and macro-prudential policies alongside inflation targeting

Critiques of inflation targeting

Neglect of output and employment

• Critics argue that inflation targeting places too much emphasis on price stability at the expense of economic growth and employment
• Strict adherence to inflation targets may lead to unnecessarily tight monetary policy during economic downturns
• Some argue for a dual mandate that includes both price stability and maximum employment (e.g., the US Federal Reserve)

Difficulty in managing asset bubbles

• Inflation targeting primarily focuses on consumer price inflation, which may not capture asset price inflation (e.g., housing, stocks)
• Asset price bubbles can pose risks to financial stability and the real economy
• Some critics argue that inflation targeting should be complemented by macro-prudential policies to address asset price bubbles

Limitations during economic crises

• Inflation targeting may be less effective during severe economic downturns or financial crises
• When interest rates are close to the zero lower bound, conventional monetary policy tools may be constrained
• Unconventional monetary policies (e.g., quantitative easing) may be necessary to stimulate the economy and maintain price stability

Future of inflation targeting

Modifications to inflation targeting framework

• Considering alternative measures of inflation (e.g., core inflation, trimmed mean inflation) to better capture underlying price pressures
• Adopting a more flexible approach to inflation targeting, such as a target range instead of a point target
• Incorporating forward guidance and state-contingent policy commitments to enhance the effectiveness of monetary policy

Integration with financial stability objectives

• Recognizing the importance of financial stability for the overall health of the economy
• Incorporating macro-prudential policies alongside inflation targeting to address systemic risks and asset price bubbles
• Enhancing coordination between monetary policy and financial regulation to promote both price stability and financial stability

Inflation targeting in low interest rate environments

• Adapting inflation targeting to the challenges posed by persistently low interest rates and the effective lower bound
• Considering alternative monetary policy tools, such as negative interest rates or yield curve control
• Exploring the use of make-up strategies (e.g., price level targeting, average inflation targeting) to address past inflation shortfalls
• Assessing the potential benefits and risks of raising the inflation target to provide more policy space in low interest rate environments