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.

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.

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 crises. By signalling inflation rates as an explicit goal, the Federal Reserve hoped that it would help promote its dual mandate: low unemployment supporting stable prices.

investopedia