Inflation Targeting
Inflation targeting is a monetary policy framework in which the central bank commits to achieving a specified rate of inflation, usually expressed as a target or a target range, and uses its policy instruments to guide inflation toward that target. The framework, adopted by many central banks since the 1990s, combines a numerical target, an institutional commitment to price stability, and a high degree of transparency and accountability. It has become one of the dominant approaches to monetary policy in both advanced and emerging economies.
Elements of the framework
An inflation targeting framework has several elements. A numerical target, such as two per cent per year, provides a benchmark against which performance can be judged and anchors expectations. An institutional commitment to price stability as the primary objective of monetary policy, often supported by legal provisions and by the independence of the central bank, strengthens credibility. A forward-looking approach, using forecasts and analysis of the transmission of policy, guides decisions toward the target over the relevant horizon.
Transparency and accountability are central. Central banks publish their forecasts, the reasoning behind their decisions, and regular reports on performance, and they explain deviations from the target. Communication with the public and with markets is used to shape expectations, because the effectiveness of policy depends on the credibility of the commitment. Independence from political pressure supports the framework, since the target is more likely to be met when decisions are insulated from short-term political considerations.
Operating the framework
In practice, inflation targeting is flexible. Because inflation responds to policy with a lag, central banks target inflation over a horizon, typically one to three years, rather than trying to control it month by month. They consider a range of indicators, including measures of demand pressure, wages, exchange rates, and expectations, and they balance the objective of price stability against the objective of stabilising output and employment.
The policy instrument is usually a short-term interest rate, which the central bank adjusts to influence demand and, eventually, inflation. When inflation is above target and expected to remain so, the central bank raises rates; when it is below target, it lowers them. Communication about the path of policy, including forward guidance, is used to influence expectations about future rates, which in turn affect current financial conditions and spending.
Advantages
The framework has several advantages. By focusing on a numerical target, it provides a clear anchor for expectations, which helps to stabilise inflation and to make monetary policy more effective. It enhances transparency and accountability, since the central bank must explain its decisions and report on outcomes, and it clarifies the objectives of policy to the public and to markets. These features can improve the credibility of the central bank and reduce the cost of disinflation.
The framework also imposes discipline. By committing to a target, it reduces the temptation to use monetary policy for short-term political gain or to finance fiscal deficits. In emerging economies, where inflation has often been high and central bank credibility weak, the framework has been associated with lower and more stable inflation, and it has helped to anchor expectations during periods of volatility.
Criticisms and challenges
Criticisms focus on several issues. A strict focus on inflation may lead the central bank to neglect other objectives, such as output and employment, although in practice most frameworks are flexible and consider these objectives. The framework may be difficult to operate when the transmission of policy is weak, when inflation is driven by supply shocks, or when the exchange rate is volatile, and it may be less effective when the policy rate is at its lower bound and cannot be reduced further.
The framework also faces challenges from the global environment. Global factors, including commodity prices, trade, and financial conditions, influence domestic inflation, and the central bank may have limited control over them. In economies with large external exposure, the exchange rate and capital flows complicate the conduct of policy, and the choice between stabilising inflation and stabilising the currency may be difficult. The framework must therefore be adapted to the circumstances, and many central banks use it flexibly rather than mechanically.
Flexible inflation targeting
In practice, most inflation targeting central banks operate a flexible framework that also responds to output and employment. The central bank seeks to return inflation to target over a horizon, but it does so while avoiding excessive volatility in output, and the weight given to output stabilisation reflects the mandate and the circumstances. This flexibility is described in the framework documents of central banks and is reflected in their decisions and communication.
The flexible framework also allows the central bank to look through temporary price shocks, such as those arising from changes in commodity prices, and to respond only to developments that are expected to affect inflation persistently. This approach avoids unnecessary volatility in output while still anchoring inflation expectations. The distinction between the response to temporary and persistent shocks is central to the practical implementation of inflation targeting.
Communication and expectations
Communication is a central tool of inflation targeting. Central banks publish forecasts, explain the reasoning behind their decisions, and hold regular press conferences and testimony to communicate their assessment. The purpose is to shape expectations, because private expectations of inflation influence wage and price setting and therefore the actual inflation outcome. A credible commitment to the target makes the central bank's job easier, since expectations do more of the work.
Modern frameworks place heavy emphasis on forward guidance, in which the central bank describes the likely path of policy and the conditions under which it will change. This guidance helps markets and households to anticipate policy, reducing uncertainty and improving the transmission of policy. It must, however, be conditioned on the outlook, since commitments that are unconditional can become inappropriate if circumstances change, and the design of guidance therefore balances clarity against flexibility.
Challenges in emerging economies
Emerging economies face particular challenges in operating inflation targeting. Their inflation is more volatile, because they are more exposed to commodity price shocks and to exchange rate movements, and the pass-through of exchange rate changes to domestic prices can be larger. Their central banks may have less credibility, so that expectations are less well anchored and the cost of disinflation is higher. The financial system may be less developed, so that the transmission of policy through credit and interest rates is weaker.
These challenges have led to adaptations. Some central banks use a wider target range, or a target for underlying inflation that excludes volatile items, to avoid frequent misses and to preserve credibility. Some intervene in foreign exchange markets or use macroprudential tools to limit financial stability risks, in addition to setting interest rates. The frameworks are therefore tailored to local conditions, and the experience shows that inflation targeting can work in a range of economies when it is adapted appropriately.