is a framework where central banks set explicit inflation rate targets as their primary goal. This approach aims to maintain price stability, anchor , 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 . 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 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 )
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., , 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 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