Inflation Targeting
What is Inflation Targeting?
Inflation targeting is a framework in which a central bank publicly commits to a numerical inflation goal and sets policy to reach it over the medium term.
The central bank announces a target for a named price index, publishes forecasts, and explains itself when it misses. The purpose is to anchor expectations, because if firms and workers believe inflation will return to the target, they set prices and wages on that basis, which makes the target partly self-fulfilling and lowers the output that has to be given up to keep inflation down. Targets are set slightly above zero rather than at zero, both to leave room to push real rates below zero in a downturn and because standard price indexes tend to overstate the true rise in the cost of living. A target is a goal for an outcome, not an instrument. The policy rate is the instrument, and most targeters run a flexible version that also weighs output and employment.
Inflation Targeting: a worked example
Suppose a central bank targets 2 percent inflation and inflation arrives at 5 percent. A Taylor-type rule that raises the nominal policy rate by 1.5 points for every point of excess inflation calls for 3 × 1.5 = 4.5 points of tightening. Since the nominal rate rises by 4.5 while inflation rose by 3, the real rate rises by 4.5 minus 3 = 1.5 points, and demand cools. Had the bank raised the nominal rate by only 2 points, the real rate would have fallen by 1 point, loosening policy in the middle of an overshoot. Responding more than one-for-one is what makes a target bite.
The mistake students make with inflation targeting
Students read the target as a rule the bank must hit every year, and treat any miss as failure. Targets are medium-term: a supply shock can hold inflation away from target for a while, and a bank that forced it straight back would cause a needless recession. The other half of the mistake is assuming the ideal target is zero, when a small positive number is chosen deliberately.
Inflation Targeting questions
Why do central banks target positive inflation instead of zero?
Central banks target a small positive rate, often around 2 percent, so the policy rate has room to fall and still deliver a negative real rate in a downturn. A zero target also leaves an economy one shock away from deflation, and because standard price indexes overstate inflation slightly, a measured zero would already be mild deflation.
How does inflation targeting anchor expectations?
Inflation targeting anchors expectations by making the goal public and every miss explainable, so people forecast inflation near the target instead of extrapolating from whatever happened last. Anchored expectations feed into wage bargains and price setting, which lets a temporary shock pass through without turning into persistent inflation.
Does inflation targeting mean the central bank ignores unemployment?
No, nearly every inflation targeter runs a flexible version that returns inflation to target gradually so output and employment are not sacrificed more than necessary. Some central banks operate an explicit dual mandate covering both price stability and maximum employment, and even a strict targeter watches output because it drives future inflation.
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