Inflation Targeting
A central banking strategy that involves modifying the monetary policy to attain a specific annual rate of inflation.
What is Inflation Targeting?
A central banking strategy known as inflation targeting involves modifying the monetary policy to attain a specific annual rate of inflation.
Maintaining price stability, which is accomplished by reducing inflation, is the greatest way to promote long-term economic growth.
As a strategy, inflation targeting sees preserving price stability as the central bank's key objective. A general inflation targeting strategy can use all the monetary policy tools available to a central bank, such as open market operations and discount lending.
Compared to other central bank tactics, such as targeting currency exchange rates, the unemployment rate, or the pace of nominal gross domestic product (GDP) growth, inflation targeting focuses on a single indicator of economic performance.
Central banks may utilize interest rates to target inflation as an intermediate goal. It will either maintain, raise, or cut interest rates, depending on whether the central bank believes inflation is at, above, or below a goal threshold.
Raising interest rates is supposed to slow inflation and hinder economic growth. But conversely, it is thought that lowering interest rates hastens economic expansion and increases inflation.
A price index for various consumer items, such as the Personal Consumption Expenditures Price Index used by the U.S. Federal Reserve, serves as the standard for inflation targeting.
Inflation targeting policies may have established actions that are to be taken depending on how much the actual inflation rate deviates from the targeted level, such as lowering lending rates or boosting liquidity in the economy.
Key Takeaways
- Specifying an inflation rate as a target and modifying the monetary policy to accomplish it is known as inflation targeting.
- While maintaining price stability is the primary objective, its proponents also contend it promotes economic stability and growth.
- Stable inflation lessens investor uncertainty and helps investors predict changes in interest rates and inflation expectations.
- The Taylor rule is often used to forecast future interest rates using a variety of inputs, such as population, poverty rate, and inflation.
- It allows central banks to respond to domestic economic shocks and focus on domestic problems.
- The targeting of inflation can be compared to other potential central banking policy objectives, such as the targeting of exchange rates, unemployment, or national income.
What Is Inflation?
The loss of a currency's relative purchasing power over time is called inflation.
The average price level of a basket of chosen goods and services in an economy, over time, can provide a quantitative approximation of the rate at which buying power reduces/increases.
A unit of money now buys less than it did in earlier periods due to the increase in prices, which is frequently stated as a percentage. This is known as inflation.
Deflation, on the other hand, is characterized by an increase in the purchasing power of money and a decrease in prices.
Though it may manifest through other economic mechanisms, a rise in the money supply is the primary cause of inflation. As a result, businesses can prepare for the future because they know what to expect when prices are stable or when inflation is reasonably consistent.
The Fed believes this will encourage maximum employment, which is based on non-monetary factors that change over time and are subject to change.
Because of this, the Fed doesn't set a clear target for maximum employment; instead, it primarily depends on what companies think.
Maximum employment does not equate to zero unemployment because there is always some cyclicality when people quit and start new careers.
Since the increase in stock prices includes the consequences of inflation, stocks are regarded as the best hedge against price increases.
Most of the immediate impact on prices occurs in financial assets priced in their domestic currencies, such as equities.
This is because additions to the money supply in practically all modern countries occur through bank credit injections through the financial system.
Analyzing target inflation
Targeting inflation is simple, at least in theory. The central bank projects where inflation will go in the future and compares that to the desired inflation rate, the rate the government believes is appropriate for the economy.
How much monetary policy needs to be modified depends on the discrepancy between the prediction and the target.
While other nations have specified a target rate or an upper limit to inflation, some have chosen targets with symmetrical ranges around a midpoint. However, most nations have placed their inflation goals at low single-digit levels.
The method has prioritized reaching the target over the medium term—typically over a two- to three-year horizon—rather than focusing on doing so constantly. This enables short-term policy to address other goals, such as output smoothing.
Thus, targeting inflation offers a framework resembling a set of rules within which the central bank can choose how to respond to shocks.
Since the method has a medium-term focus, policymakers do not have to feel pressured to take whatever measures necessary to achieve targets on a period-by-period basis.
Two elements are necessary for inflation targeting. The first is a central bank with some degree of independence in monetary policymaking.
No central bank can be completely free from government interference, but it must have the freedom to use whatever tools it sees fit to attain the desired inflation rate. Concerns about fiscal policy cannot determine monetary policy.
The second prerequisite is the competence and willingness of the monetary authorities to refrain from focusing on other measures such as salaries, employment levels, or exchange rates.
A nation may, in theory, conduct monetary policy with inflation targeting if these two fundamental conditions are met. However, in actuality, the government may alternatively carry out the following actions first:
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For a predetermined number of periods, establish explicit quantitative targets for inflation.
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Make it very obvious to the public that achieving the inflation target comes before all other goals of monetary policy.
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Create an inflation forecasting model or approach that uses several indicators that provide future inflation information.
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Create a forward-looking operational method that will allow the chosen target to be reached by adjusting monetary policy tools by predictions of future inflation.
What is the Taylor Rule?
The U.S. Federal Reserve and other central banks can use the Taylor rule as guidance when making short-term interest rate adjustments in response to changes in economic conditions like inflation and the unemployment rate.
This rule is named after John B. Taylor, a Stanford University economist. He developed it in 1993 to alter and establish prudent interest rates that not only assisted in short-term economic stabilization but also promoted long-term growth.
Real short-term interest rates are determined by three factors, according to the Taylor rule:
- The difference between the desired and actual levels of inflation
- Real employment rates in relation to full employment
- A short-term interest rate that is consistent with full employment
With many inputs, including population, poverty rate, and inflation, the Taylor rule is frequently used to predict future interest rates.
The results of applying this rule are meant to serve as instructions for the Federal Reserve as it adjusts interest rates based on widely used factors like inflation and the unemployment rate. Following are some general guidelines for using the Taylor rule:
- Interest rates should be hiked when inflation is high, or employment exceeds the level of full employment.
- In contrast, interest rates should be cut during times of low inflation and/or low employment levels.
Formula
The Taylor rule's basic formula for determining appropriate interest rates is given below:
Target Rate = Neutral rate + 0.5 * (GDPe - GDPt ) + 0.5 * (Ie - It )
Where:
- Target rate: The short-term interest rate that the central bank should aim for
- Neutral rate: The present short-term interest rate when there is no difference between actual and anticipated GDP growth rates
- GDPe: Expected GDP growth rate
- GDPt: Long-term GDP growth rate
- Ie: Expected inflation rate
- It: Target inflation rate
Pros and Cons of Inflation Targeting
Inflation targeting allows central banks to respond to shocks to the domestic economy and concentrate on consumer issues.
Investor uncertainty is reduced by stable inflation, which also enables investors to anticipate changes in interest rates and grounds inflation expectations.
It also promotes more openness in monetary policy if the aim is made public.
Some economists, however, contend that reliance on inflation targeting for price stability fosters an environment in which unsustainable speculative bubbles and other economic distortions, like those that led to the 2008 financial crisis, can flourish.
Other opponents contend that it promotes ineffective responses to supply or terms-of-trade shocks. Critics contend that targeting the nominal GDP or the exchange rate would produce more stable economic conditions.
When inflation or GDP growth rates are higher than intended, the Federal Reserve should raise interest rates, according to the Taylor rule, an econometric model.
As a practical response to the failure of alternative monetary policy regimes, such as those that targeted the money supply or the value of the currency relative to another, several central banks chose inflation targeting.
Let us summarize the pros and cons of inflation targeting:
Pros are:
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Increased accountability and transparency can occur.
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With some short-term flexibility, the policy is tied to medium- and long-term objectives.
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People will typically have modest inflation expectations while inflation targeting is in place. Without an inflation target, people could anticipate increased inflation, which might lead to salary demands from employees and price increases from businesses.
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Additionally, it aids in preventing boom and bust cycles.
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If inflation starts to creep up, it can have a variety of negative economic effects, including diminished investment, decreased international competitiveness, and a decreased value of savings. Targeting helps to prevent all of these adverse effects.
Cons are:
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In comparison to other objectives, inflation may be given too much weight. Central banks may start to ignore more pressing issues such as unemployment.
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The inflation target reduces flexibility. In some cases, where doing so would not be advisable, it can potentially restrain policy.
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A brief spike in inflation may be brought on by cost-push inflation.
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Lack of supplies and supply bottlenecks cannot be resolved by inflation targeting.
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External shocks cannot be prevented, and the exchange rate may drop temporarily.
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In the medium term, growth and employment may suffer.
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