Econs Primer: Inflation targeting, a central bank policy for price stability

Practice, Practice...on the medium term!

Credit: Pete on flickr

Definition:

Inflation targeting is a commitment by the central bank to keep the inflation rate close to an agreed level as a tool of monetary policy, and making this commitment known publicly.

Inflation targeting was started by New Zealand 20 years ago when it announced that it was making controlling inflation its primary policy objective while emphasizing transparency and accountability in achieving that target. Many other developed economies have followed the example of New Zealand, including the United Kingdom and Japan.

Other countries like the United States who have not followed it as of today, March 2015, have imbibed the spirit of inflation targeting in her policy pronouncements.

Goals of Inflation targeting:

1. Price stability.

When the target inflation is known by all the stakeholders in the economy, it helps them in planning for now and the future. Therefore, prices do not move erratically based on the expectations of the market.

2. Operational autonomy:

A central bank that is accountable to the public is usually given a wide margin of operational autonomy by the government to operate freely unless public opinion turns against it. This implies the central banks pursue a unintended policy of public relations with the citizenry in mind. There is a fear that this might politicize the process inadvertently.

3. Avoid high inflation.

Many of the countries with an inflation target, notably the UK, stick to an inflation target of 2%+/- 1.0. High inflation which can destabilize the economy and bring about high unemployment is hence avoided or fought quickly. High inflation also increases the inequality in the country.

4. Effective monetary policy.

By making stakeholders in the economy part of the central banks policy briefings through a transparent and accountable process, its effectiveness in driving monetary policy is enhanced.

Benefits of inflation targeting:

• Policy transparency and accountability.

It is a fact that inflation targeting brings about a progressive increase in policy transparency and accountability. Communication becomes the key of providing public accountability. In the light of the fact that central banks gain a high degree of autonomy, this is the advisable course of action.

• Avoiding recessions.

If high inflation is curtailed, recessions and depressions are avoided. A recession though somewhat ambiguous refers to a period of reduced GDP growth and elevated unemployment while a depression is a large and protracted recession.

• Low inflation expectations.

When have low inflation expectations and they believe it is reasonable to do so, they put less pressure on wages and salaries, thereby prices and margins which firms set become reasonable.

• Central Bank flexibility.

Although inflation targeting is the primary policy objective of the central bank, it gives it the ability of pursuing other objectives like smoothing output. Inflation targeting is usually set within a medium term framework i.e two-to-three years horizon, hence, while the timeline ticks, it pursues other objectives in the short term which would help make its medium term goals, notably low inflation expectations, well anchored.

Challenges of adopting inflation targeting:

Some of the challenges encountered over the 20 year history of inflation targeting are:

• There is a debate over what role the exchange rate will play in an inflation targeting framework.
• The question remains on how to reconcile monetary policy responsibilities and objectives with a responsibility to maintain the stability of the financial system.
• Inflation targets become a “religion” at the expense of other pressing problems. The fixation on inflation and the level of inflation on a daily basis becomes a disadvantage while other problems like unemployment or supply-side shocks suffer. Supply-side shocks and unemployment are also a subject of the medium term.
• The central bank is faced with an uphill task if it faces public opposition.