What Is Inflation Targeting, and How Does It Work?

What Is Inflation Targeting?

Inflation targeting is a central banking policy that revolves around adjusting monetary policy to achieve a specified annual rate of inflation. This is known as the target rate, which is normally set at around 2% to 3%.

The principle of inflation targeting is based on the belief that long-term economic growth is best achieved by maintaining price stability, and price stability is achieved by controlling inflation.

Inflation targeting can be compared with other central bank operating targets, such as price-level targeting and nominal gross domestic product (GDP) targeting.

Key Takeaways

  • Inflation targeting is a central bank strategy of specifying an inflation rate as a goal and adjusting monetary policy to achieve that rate.
  • Inflation targeting primarily focuses on maintaining price stability, but its proponents also believe that it supports economic growth and stability.
  • Inflation targeting can be contrasted to other possible policy goals of central banking, including the targeting of exchange rates, unemployment, or national income.
  • Generally, central banks have set their target at 2% to 3% annual inflation.
  • Inflation targeting appeared in 1990 when the Bank of New Zealand first deployed it. Today, it is used by most of the world's central banks.
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Monetary Inflation

Understanding Inflation Targeting

As a strategy, inflation targeting views the primary goal of the central bank as maintaining price stability. All of the tools of monetary policy that a central bank has—including open market operations (OMO) and discount lending—can be employed in a general strategy of inflation targeting. Inflation targeting can be contrasted to strategies of central banks aimed at other measures of economic performance as their primary goals, such as targeting currency exchange rates, the unemployment rate, or the rate of nominal GDP growth.

Interest rates can be an intermediate target that central banks use in inflation targeting. The central bank will lower or raise interest rates based on whether it thinks inflation is below or above a target threshold. Raising interest rates is said to slow inflation and therefore slow economic growth. Lowering interest rates is believed to boost inflation and speed up economic growth.

The benchmark used for inflation targeting is typically a price index of a basket of consumer goods, such as the Consumer Price Index (CPI) or Personal Consumption Expenditures (PCE) Price Index, which is now used by the U.S. Federal Reserve.

Along with taking inflation target rates and calendar dates as performance measures, inflation targeting policy may also have established steps that are to be taken depending on how much the actual inflation rate varies from the targeted level, such as cutting lending rates or adding liquidity to the economy.

Inflation targeting became a central goal of the Federal Reserve in January 2012 after the fallout of the 2008-2009 financial crisis. By signaling inflation rates as an explicit goal, the Federal Reserve hoped that it would help promote its dual mandate: low unemployment supporting stable prices.

Pros and Cons of Inflation Targeting

Inflation targeting allows central banks to respond to shocks to the domestic economy and focus on domestic considerations. Stable inflation reduces investor uncertainty, allows investors to predict changes in interest rates, and anchors inflation expectations. If the target is published, inflation targeting also allows for greater transparency in monetary policy.

However, some analysts believe that a focus on inflation targeting for price stability creates an atmosphere in which unsustainable speculative bubbles and other distortions in the economy, such as that which produced the 2008 financial crisis, can thrive unchecked (at least until the inflation trickles down from asset prices into retail consumer prices).

Other critics of inflation targeting believe that it encourages inadequate responses to terms-of-trade shocks or supply shocks. Critics argue that exchange rate targeting or nominal GDP targeting would create more economic stability.

Pros and Cons of Inflation Targeting

Pros
  • Increased central bank transparency and accountability

  • Allows investors and the public to anticipate interest rate changes

  • Lowers inflation expectations

Cons
  • Inflexible

  • Can promote speculative bubbles

  • Inflation may not be the right target to promote economic stability

  • Can constrain economic growth in some economies

How Are Inflation Targets Used in Monetary Policy?

Inflation targets are used by central banks to employ monetary policy, such as setting interest rates. The Taylor Rule is an econometric model that says that a central bank should raise interest rates when inflation or GDP growth rates are higher than desired, and vice-versa.

Does the Fed Use Inflation Targeting?

Since 2012, the U.S. Federal Reserve has targeted an inflation rate of 2% as measured by PCE. Keeping inflation low is one of the Federal Reserve's dual mandate objectives, along with stable and low unemployment levels.

The Taylor Rule equation is typically written as:

r = p + 0.5y + 0.5(p - 2) + 2

Where:

  • r = nominal fed funds rate
  • p = the rate of inflation
  • y = the percent deviation between current real GDP and the long-term linear trend in GDP 

The equation assumes the equilibrium federal funds rate of 2% above inflation, represented by the sum of p (inflation rate) and the "2" on the far right.

What Is a Typical Inflation Target?

Inflation levels of 1% to 2% per year are generally considered acceptable, while inflation rates greater than 3% to 4% can represent an overheating economy. Even higher rates of inflation can cause the currency to become devalued.

Which Country First Used Inflation Targeting?

New Zealand is credited with being the first country to explicitly use inflation targeting for its monetary policy starting in 1990. Today, most central banks use some form of inflation targeting.

The Bottom Line

Inflation targeting is a goals-based approach to monetary policy whereby a central bank seeks a specific annual rate of inflation for a county's economy (normally around 2% or 3% per year). The central bank can then use a range of policy measures such as setting interest rates or open market operations to maintain that target.

Research suggests that economies become more resilient and prices more stable once inflation targeting has been adopted, although some economists critique the measure as ineffective—for instance, in the decade following the 2008 financial crisis, when inflation remained well below the target rate in many countries for years. More recently, inflation has surged above the target rate around the globe in 2022.

Article Sources
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  1. Federal Reserve Bank of San Francisco. "Economic Research-Indicators and Data-PCE Inflation Dispersion."

  2. National Bureau of Economic Research. "Rational Speculative Bubbles in an Exchange Rate Target Zone."

  3. Brookings Institution. "Central Banks Must Target Growth Not Inflation."

  4. Brookings Institution. "What Do Changes in the Fed's Longer-Run Goals and Monetary Strategy Statement Mean?"

  5. International Monetary Fund. "Inflation Targeting: Holding the Line."

  6. Arsić, Milojko, Zorica Mladenović, and Aleksandra Nojković. "Macroeconomic performance of inflation targeting in European and Asian emerging economies." Journal of Policy Modeling, Vol. 44, No. 3. 2022. Pp. 675-700.

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