Inflation targeting is mainly a policy framework wherein a Central Bank estimates an inflation rate target. And, through appropriate monetary policy tools, Central Banks ensure that actual inflation gets close to the inflation rate target.
At first, the Central Bank would estimate the quantitative inflation rate target for the medium & long term. And, it communicates both the reasons for such a decision and the path it’s going to adopt to achieve the inflation rate target.
New Zealand was the first country to adopt the Inflation targeting framework back in the year 1989. Ever since many Central Banks have adopted the framework. The inflation rate target isn’t the same for every economy. Central banks choose a target they find well suited for the economy over the medium and long term.
Inflation rate targeting
In the United States, to pursue maximum employment and price stability, the Federal Open Market Committee (FOMC) has an inflation rate target of 2% over the longer term.
To achieve the Inflation rate target, Central Banks should be able to make decisions without any Government intervention. If both the Government & Central Bank aren’t on the same page then, it would make things difficult for the Central Bank to achieve the inflation rate target.
In the year 2022, when the inflation rate hit multi-decade highs, US Federal Reserve sought to bring it back to its long-term of target 2%. To achieve that, it has used various monetary policy tools and that includes making changes in interest rates. As inflation hit multi-decade highs, US Federal Reserve has raised interest rates at every FOMC meeting since March 2022. And, it is expected to do the same in Jan/Feb FOMC meeting as well.
Other Central Banks have followed suit. Central Banks across the world have raised interest rates to bring the inflation rate down. But, here inflation rate targets vary for every economy. For the US, UK & ECB it’s 2% over the medium and long term. Whereas, it is much higher for Emerging economies.
The actual impact of monetary policy tools gets visible with a lag. It takes at least two quarters before we see the changes in data.
When Central Banks begin to increase interest rates, it lowers inflation expectations. What it does is – firms and households, defer their purchases in the expectation prices would get attractive later. This impacts the overall demand in the economy. And, the softening of demand pushes prices lower eventually.
Until now, we have covered what happens when Central Banks want to cool the economy down. The inflation is running higher than their target range. And, they wish to bring it down by using various monetary policy tools including interest rates.
But, what if the inflation rate is lower than the target range of the Central Bank? In that case, the Central Bank would have to reduce interest rates. Again, inflation expectations would come to play. When firms and households expect prices to rise in the medium term they would invest or make purchases now rather than later. That preps the wheel of Economic growth.
Inflation rate targeting – Pros and Cons
It makes the Central Banks accountable for their actions. They communicate the path they intend to follow to bring inflation back to its target range. That helps households and firms take informed decisions.
When Central Banks use monetary policy tools to bring inflation down, it does impact both households and firms. For households, it is the fear of being unemployed and loss of income. While Firms have to manage with lower revenue. In the rising interest rate environment, those who have debt on their Balance Sheet may have a tough time. But, it is necessary to do so in the larger interest. The inflation rate if allowed to run higher for the long term can push the poor to the brink. Higher prices reduce the savings rate and ultimately the investment.
It can also fuel speculative bubbles. If the underlying strength of the economy is missing then, this brings greater pain. Consider a scenario, if Central Banks can’t achieve a soft landing while bringing inflation down. Then, it may lead to higher unemployment, reduced wages, etc. which ultimately ends in a recession. Though Central Banks have the right monetary policy tools to bring the economy back from the recession. But, that doesn’t apply to all. If that is the case, then it requires considerable time and effort from the Government and Central Bank to bring the economy back to its healthy zone.
