Inflation targeting is common practice around the world today. It describes the operating strategy of central banks which set an explicit target for the inflation rate in advance. They then use monetary policy to achieve the inflation target. Thereby the target can take a variety of forms, such as:
- an inflation range without a midpoint, e.g. 1 to 3 percent
- an inflation range with a preferred midpoint, e.g. 2 percent +/- 1 percent
- a specific inflation target number, e.g. 2%
- an upper bound inflation target, e.g. <2%
Inflation targeting was first introduced by the Reserve Bank of New Zealand in the ‘Reserve Bank of New Zealand Act 1989’. The Act set out a CPI inflation band of 0 to 2 percent per year. It was later changed to a band of 1 to 3 percent with a 2 percent inflation target midpoint (RBNZ, 2009; 2016). Since then many countries have followed New Zealand, such as Canada, Switzerland or the UK.
In contrast to the Taylor rule for monetary policy, inflation targeting anticipates future inflation and attempts to bring the expected or forecast inflation rate in line with the desired inflation rate. The Taylor rule, on the other hand, is based on past inflation rates. It sets the interest rate based on a broader assessment of both the output gap and the past inflation rate (Krugman and Wells, 2009). Most notably, the Federal Reserve (USA) used some variant of the Taylor rule until 2012, but shifted to an inflation targeting regime when the former Chairman Ben Bernanke announced an inflation target of 2 percent in 2012 (Spicer, 2012).
Inflation targeting has evolved due two 2 major advantages: (1) transparency and (2) accountability. The practice of inflation targeting is transparent, because the Central Bank will clearly communicate its inflation rate targets to the public. The public will therefore be able to anticipate or expect interest rate changes and the use of other tools of the Central Bank in order to achieve the inflation target. The practice of inflation targeting also allows for accountability as the Central Bank’s actual performance can be evaluated against its targets. Furthermore, proponents of inflation targeting also argue that a third advantage is increased economic stability due to reduced inflation volatility or a reduction in the inflationary impact of shocks (FRBSF, 2007; Jahan, 2012).
Key drawbacks of inflation targeting are its restrictiveness and potential for poor macroeconomic outcomes. Inflation targeting may be too restrictive during a turmoil or recession such as the global financial crisis when the stability of the financial system becomes the key priority (Krugman and Wells, 2009). It may also be the cause for poor outcomes in other macroeconomic variables. Employment is the best example with its short-run trade-off between inflation and unemployment (FRBSF, 2007).
Let’s take a closer look at the different inflation targeting regimes around the world. Firstly, there are Switzerland and the Euro area, which have an upper bound on inflation of 2 percent. Then there is a range of countries which target a specific rate. Russia for example targets 4 percent (for 2017) while Norway targets 2.5 percent inflation per annum. The numbers range from 2 percent (Sweden, South Korea and USA) to 14.2 percent in Malawi (for the fiscal year ending June 2016; Mzale, 2016), followed by 12 percent in Belarus. The most common inflation targeting regime, however, is to set a band with a desired midpoint. Five countries have adopted a 2 percent midpoint with a leeway of 1 percent in both directions and six countries have adopted a 3 percent midpoint with a leeway of 1 percent. The midpoint inflation targets range from 2 percent to 8 percent (Ghana). Some countries have adopted narrow bands of +/- 1 percent while others are allowing for a deviation of +/- 2 percent. Outlier Kenya currently allows for a deviation of even +/- 2.5 percent from its midpoint target of 5 percent. Lastly, there are ten countries which have set a band without a particular midpoint. South Africa for example has adopted a band of 3 to 6 percent while Uruguay even allows for 3 to 7 percent. In contrast, Australia allows for 2 to 3 percent inflation per annum and has the narrowest band of only 1 percent together with Azerbaijan out of all countries which set lower and upper bounds (Central Bank News, 2016).
Overall it’s interesting to see how inflation targeting has evolved over the last two and a half decades and – although there are arguably major benefits and costs to inflation targeting – it remains a common practice. It has survived the global financial crisis with new countries like the US jumping on the bandwagon recently. Whether this operating strategy will prove successful? Time will tell; however, its long-run performance is likely to be different from the short-run. This is why today countries are often allowed to deviate from their targets for shorter periods of, for example, not more than 12 months (New Zealand; RBNZ, 2009).
Thanks for reading!
Central Bank News (2016). Inflation Targets Table for 2016. http://www.centralbanknews.info/p/inflation-targets.html
FRBSF (2007). What are the costs and benefits of inflation targeting? Should the Fed adopt an inflation targeting monetary policy regime? Retrieved from:
Jahan, S. (2012, 28 March). Inflation Targeting: Holding the Line. Retrieved from: http://www.imf.org/external/pubs/ft/fandd/basics/target.htm
Krugman, P., & Wells, R. (2009). Macroeconomics (2nd ed.). New York, N.Y.: Worth Publishers.
Mzale, D. (2016, 8 January). Government maintains 14.2% inflation target. Retrieved from: http://mwnation.com/government-maintains-14-2-inflation-target/
RBNZ (2009). Explaining New Zealand’s Monetary Policy [pdf]. Retrieved from: http://www.rbnz.govt.nz/-/media/ReserveBank/Files/Publications/Factsheets%20and%20Guides/factsheet-explaining-new-zealands-monetary-policy.pdf
RBNZ (2016). Official Cash Rate (OCR) decisions and current rate. Retrieved from: http://www.rbnz.govt.nz/monetary-policy/official-cash-rate-decisions
Spicer, J. (2012, 25 January). In historic shift, Fed sets inflation target [online]. Reuters. Retrieved from: http://www.reuters.com/article/us-usa-fed-inflation-target-idUSTRE80O25C20120125