Inflation targeting is a central banking policy that revolves around adjusting monetary policy to achieve a specified annual rate of inflation. 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.
Features of Inflation Targeting
- Inflation targeting primarily focuses on maintaining price stability, but is also believed by its proponents to support 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.
- All of the tools of monetary policy that a central bank has, including open market operations and discount lending, can be employed in a general strategy of inflation targeting.
- 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.
- The benchmark used for inflation targeting is typically a price index of a basket of consumer goods, such as the Consumer Price Index.
- Stable inflation reduces investor uncertainty, allows investors to predict changes in interest rates, and anchors inflation expectations. If the target is published, inflation targeting also allows for greater transparency in monetary policy.
- Critics argue that exchange rate targeting or nominal GDP targeting would create more economic stability.
- Some countries have chosen inflation targets with symmetrical ranges around a midpoint (4%+/-2%), while others have identified only a target rate or an upper limit to inflation. Most countries have set their inflation targets in the low single digits.
- A major advantage of inflation targeting is that it combines elements of both “rules” and “discretion” in monetary policy. This “constrained discretion” framework combines two distinct elements: a precise numerical target for inflation in the medium term and a response to economic shocks in the short term.
Other Approaches of Monetary Policy
- The exchange rate targeting regime means that the central bank pegs the value of the national currency to the exchange rate (basket of currencies) of the country (countries) with a low inflation rate, i.e. an intermediate goal of monetary policy is a certain level of or change in the exchange rate.
[In order to effectively use this regime, the country should have a substantial volume of gold and foreign exchange reserves to counter shocks in the foreign exchange market].
- The monetary targeting regime uses one of the money supply indicators as an intermediate target. The instruments for regulating the banks’ liquidity are the main tool for achieving the monetary policy objectives.