What Is Inflation Targeting?

Inflation targeting is a central banking policy that revolves around meeting preset, publicly displayed targets for the annual rate of inflation. Inflation targeting is based on the belief that long-term economic growth is best served by maintaining price stability, and that is done by controlling inflation.

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Monetary Inflation

Understanding Inflation Targeting

Interest rates are the primary tool 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) in the United States.

Along with inflation target rates and calendar dates to be used 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.

Pros and Cons of Inflation Targeting

Inflation targeting allows central banks to “respond to shocks to the domestic economy” and “focus on domestic considerations.” It reduces investor uncertainty, allows investors to predict changes in interest rates, and anchors inflation expectations. It 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, such as that which produced the 2008 financial crisis, can thrive unchecked. Critics of inflation targeting believe that it encourages inadequate responses to terms-of-trade shocks or supply shocks. Product-price targeting or nominal income targeting would create more economic stability, they argue.

Inflation Targeting in the United States

While the U.S. central bank doesn't typically have an explicit target for inflation (unlike other countries such as Canada, Australia, and New Zealand), keeping inflation low is one of the Federal Reserve's primary concerns, along with stable growth in gross domestic product and low unemployment levels.

Inflation levels of 1% to 2% per year are generally considered acceptable (even desirable in some ways), while inflation rates greater than 3% represents a dangerous zone that could cause the currency to become devalued.

Inflation targeting became a central Fed goal in January 2012, after the fallout of the 2008-09 financial, economic, and housing crisis. By signaling inflation rates as an explicit goal, the Fed hoped it would help promote their dual mandate: low unemployment supporting stable prices. Despite the Fed’s best efforts, inflation has stubbornly resisted the 2% target for most of the past five years.

More recently, given the Fed’s inability to move inflation higher, critics are beginning to wonder if the Fed should abandon its unrelenting specific inflation targeting ambitions. With each unsuccessful passing quarter, the Fed risks damaging its credibility – not to mention it’s maintained a loose policy far longer than historical norms – both of which don’t help long-term options in the future.