Inflation targeting
Encyclopedia
Inflation targeting is an economic policy in which a central bank
estimates and makes public a projected, or "target", inflation
rate and then attempts to steer actual inflation towards the target through the use of interest rate
changes and other monetary tools.
Because interest rates and the inflation rate tend to be inversely related, the likely moves of the central bank to raise or lower interest rates become more transparent under the policy of inflation targeting. Examples:
Under the policy, investors know what the central bank considers the target inflation rate to be and therefore may more easily factor in likely interest rate changes in their investment choices. This is viewed by inflation targeters as leading to increased economic stability.
and its members, regularly publicly state a desired target range for inflation (usually 2%), but do not have an explicit inflation target. This is under debate within the Fed, since inflation targeting is usually very successful in other countries because of its transparency and predictability to the markets.
However, some counter that an inflation target would give the Fed too little flexibility to stabilise growth and/or employment in the event of an external economic shock
. Another criticism is that an explicit target might turn central bankers into what Mervyn King, now Governor of the Bank of England
, had in 1997 colorfully termed "inflation nutters" - that is, central bankers who concentrate on the inflation target to the detriment of stable growth, employment and/or exchange rates. King went on to help design the Bank's inflation targeting policy and asserts that the nuttery has not actually happened, as does Chairman of the U.S. Federal Reserve Ben Bernanke
who states that all of today's inflation targeting is of a flexible variety, in theory and practice.
For the moment, the Fed continues without the strict rules of an explicit target. Former Chairman Alan Greenspan
, as well as other former FOMC members such as Alan Blinder
, typically agreed with its benefits, but were reluctant to accept the loss of freedom involved; Bernanke, however, is a well-known advocate.
proposed a "compensated dollar" system in which the gold content in paper money would vary with the price of goods in terms of gold, so that the price level in terms of paper money would stay fixed. Fisher's proposal was a first attempt to target prices while retaining the automatic functioning of the gold standard. In his Tract on Monetary Reform (1923), John Maynard Keynes
advocated what we would now call an inflation targeting scheme. In the context of sudden inflations and deflations in the international economy right after World War I, Keynes recommended a policy of exchange rate flexibility, appreciating the currency as a response to international inflation and depreciating it when there are international deflationary forces, so that internal prices remained more or less stable.
Interest in inflation targeting schemes waned during the Bretton Woods system
(1944–1971), as they are normally inconsistent with exchange rate pegs such as those prevailing during three decades after World War II. Inflation targeting was pioneered in New Zealand in 1990, and is now also in use by the central banks in United Kingdom
(Bank of England
), Canada
(Bank of Canada
), Australia
(Reserve Bank of Australia
), South Korea
(Bank of Korea
), Egypt
, South Africa
(South African Reserve Bank
), Iceland
(Central Bank of Iceland
) and Brazil
(Brazilian Central Bank), among other countries, and there is some empirical evidence that it does what its advocates claim.
from 1989–1996, raised this concern in 2008 in response to another hike in their interest rates.
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...
estimates and makes public a projected, or "target", inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
rate and then attempts to steer actual inflation towards the target through the use of interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
changes and other monetary tools.
Because interest rates and the inflation rate tend to be inversely related, the likely moves of the central bank to raise or lower interest rates become more transparent under the policy of inflation targeting. Examples:
- if inflation appears to be above the target, the bank is likely to raise interest rates. This usually (but not always) has the effect over time of cooling the economy and bringing down inflation.
- if inflation appears to be below the target, the bank is likely to lower interest rates. This usually (again, not always) has the effect over time of accelerating the economy and raising inflation.
Under the policy, investors know what the central bank considers the target inflation rate to be and therefore may more easily factor in likely interest rate changes in their investment choices. This is viewed by inflation targeters as leading to increased economic stability.
Debate
The US Federal Reserve's policy setting committee, the FOMC (Federal Open Market Committee)Federal Open Market Committee
The Federal Open Market Committee , a committee within the Federal Reserve System, is charged under United States law with overseeing the nation's open market operations . It is the Federal Reserve committee that makes key decisions about interest rates and the growth of the United States money...
and its members, regularly publicly state a desired target range for inflation (usually 2%), but do not have an explicit inflation target. This is under debate within the Fed, since inflation targeting is usually very successful in other countries because of its transparency and predictability to the markets.
However, some counter that an inflation target would give the Fed too little flexibility to stabilise growth and/or employment in the event of an external economic shock
Shock (economics)
In economics a shock is an unexpected or unpredictable event that affects an economy, either positively or negatively. Technically, it refers to an unpredictable change in exogenous factors—that is, factors unexplained by economics—which may have an impact on endogenous economic variables.The...
. Another criticism is that an explicit target might turn central bankers into what Mervyn King, now Governor of the Bank of England
Bank of England
The Bank of England is the central bank of the United Kingdom and the model on which most modern central banks have been based. Established in 1694, it is the second oldest central bank in the world...
, had in 1997 colorfully termed "inflation nutters" - that is, central bankers who concentrate on the inflation target to the detriment of stable growth, employment and/or exchange rates. King went on to help design the Bank's inflation targeting policy and asserts that the nuttery has not actually happened, as does Chairman of the U.S. Federal Reserve Ben Bernanke
Ben Bernanke
Ben Shalom Bernanke is an American economist, and the current Chairman of the Federal Reserve, the central bank of the United States. During his tenure as Chairman, Bernanke has overseen the response of the Federal Reserve to late-2000s financial crisis....
who states that all of today's inflation targeting is of a flexible variety, in theory and practice.
For the moment, the Fed continues without the strict rules of an explicit target. Former Chairman Alan Greenspan
Alan Greenspan
Alan Greenspan is an American economist who served as Chairman of the Federal Reserve of the United States from 1987 to 2006. He currently works as a private advisor and provides consulting for firms through his company, Greenspan Associates LLC...
, as well as other former FOMC members such as Alan Blinder
Alan Blinder
Alan Stuart Blinder is an American economist. He serves at Princeton University as the Gordon S. Rentschler Memorial Professor of Economics and Public Affairs in the Economics Department, Vice Chairman of The Observatory Group, and as co-director of Princeton’s Center for Economic Policy Studies,...
, typically agreed with its benefits, but were reluctant to accept the loss of freedom involved; Bernanke, however, is a well-known advocate.
History and utilizing countries
Early proposals of monetary systems targeting the price level or the inflation rate, rather than the exchange rate, followed the general crisis of the gold standard after World War I. Irving FisherIrving Fisher
Irving Fisher was an American economist, inventor, and health campaigner, and one of the earliest American neoclassical economists, though his later work on debt deflation often regarded as belonging instead to the Post-Keynesian school.Fisher made important contributions to utility theory and...
proposed a "compensated dollar" system in which the gold content in paper money would vary with the price of goods in terms of gold, so that the price level in terms of paper money would stay fixed. Fisher's proposal was a first attempt to target prices while retaining the automatic functioning of the gold standard. In his Tract on Monetary Reform (1923), John Maynard Keynes
John Maynard Keynes
John Maynard Keynes, Baron Keynes of Tilton, CB FBA , was a British economist whose ideas have profoundly affected the theory and practice of modern macroeconomics, as well as the economic policies of governments...
advocated what we would now call an inflation targeting scheme. In the context of sudden inflations and deflations in the international economy right after World War I, Keynes recommended a policy of exchange rate flexibility, appreciating the currency as a response to international inflation and depreciating it when there are international deflationary forces, so that internal prices remained more or less stable.
Interest in inflation targeting schemes waned during the Bretton Woods system
Bretton Woods system
The Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states in the mid 20th century...
(1944–1971), as they are normally inconsistent with exchange rate pegs such as those prevailing during three decades after World War II. Inflation targeting was pioneered in New Zealand in 1990, and is now also in use by the central banks in United Kingdom
United Kingdom
The United Kingdom of Great Britain and Northern IrelandIn the United Kingdom and Dependencies, other languages have been officially recognised as legitimate autochthonous languages under the European Charter for Regional or Minority Languages...
(Bank of England
Bank of England
The Bank of England is the central bank of the United Kingdom and the model on which most modern central banks have been based. Established in 1694, it is the second oldest central bank in the world...
), Canada
Canada
Canada is a North American country consisting of ten provinces and three territories. Located in the northern part of the continent, it extends from the Atlantic Ocean in the east to the Pacific Ocean in the west, and northward into the Arctic Ocean...
(Bank of Canada
Bank of Canada
The Bank of Canada is Canada's central bank and "lender of last resort". The Bank was created by an Act of Parliament on July 3, 1934 as a privately owned corporation. In 1938, the Bank became a Crown corporation belonging to the Government of Canada...
), Australia
Australia
Australia , officially the Commonwealth of Australia, is a country in the Southern Hemisphere comprising the mainland of the Australian continent, the island of Tasmania, and numerous smaller islands in the Indian and Pacific Oceans. It is the world's sixth-largest country by total area...
(Reserve Bank of Australia
Reserve Bank of Australia
The Reserve Bank of Australia came into being on 14 January 1960 as Australia's central bank and banknote issuing authority, when the Reserve Bank Act 1959 removed the central banking functions from the Commonwealth Bank to it....
), South Korea
South Korea
The Republic of Korea , , is a sovereign state in East Asia, located on the southern portion of the Korean Peninsula. It is neighbored by the People's Republic of China to the west, Japan to the east, North Korea to the north, and the East China Sea and Republic of China to the south...
(Bank of Korea
Bank of Korea
The Bank of Korea is the central bank of South Korea and issuer of South Korean won. It was established on June 12, 1950 at Seoul, South Korea.The Bank's primary purpose is price stability. For that, the Bank targets inflation...
), Egypt
Egypt
Egypt , officially the Arab Republic of Egypt, Arabic: , is a country mainly in North Africa, with the Sinai Peninsula forming a land bridge in Southwest Asia. Egypt is thus a transcontinental country, and a major power in Africa, the Mediterranean Basin, the Middle East and the Muslim world...
, South Africa
South Africa
The Republic of South Africa is a country in southern Africa. Located at the southern tip of Africa, it is divided into nine provinces, with of coastline on the Atlantic and Indian oceans...
(South African Reserve Bank
South African Reserve Bank
The South African Reserve Bank is the central bank of South Africa. It was established in 1921 after Parliament passed an act, the "Currency and Bank Act of 10 August 1920," as a direct result of the abnormal monetary and financial conditions which World War I had brought...
), Iceland
Iceland
Iceland , described as the Republic of Iceland, is a Nordic and European island country in the North Atlantic Ocean, on the Mid-Atlantic Ridge. Iceland also refers to the main island of the country, which contains almost all the population and almost all the land area. The country has a population...
(Central Bank of Iceland
Central Bank of Iceland
The Central Bank of Iceland is the central bank or reserve bank of Iceland. It has served in this capacity since 1961, when it was created by an act of the Alþingi out of the central banking department of Landsbanki Íslands, which had had the sole right of note issuance since 1927 and had...
) and Brazil
Brazil
Brazil , officially the Federative Republic of Brazil , is the largest country in South America. It is the world's fifth largest country, both by geographical area and by population with over 192 million people...
(Brazilian Central Bank), among other countries, and there is some empirical evidence that it does what its advocates claim.
| Country | Year adopted inflation targeting | Notes |
|---|---|---|
| New Zealand | 1990 | The pioneer; See Section 8: Reserve Bank of New Zealand Act of 1989 |
| Chile | 1991 | First in Latin America |
| Canada | 1991 | |
| Brazil | 1999 | |
| Australia | 1993 | 1994 according to Bernanke |
| Israel | 1991 | |
| Mexico | 1999 | |
| South Africa | 2000 |
Shortcomings
Increases in inflation (CPI) are not necessarily coupled to any factor internal to a country's economy and adjusting strictly or blindly adjusting interest rates will potentially be ineffectual and restrict economic growth when it was not necessary to do so. Bernie Fraser, governor of Reserve Bank of AustraliaReserve Bank of Australia
The Reserve Bank of Australia came into being on 14 January 1960 as Australia's central bank and banknote issuing authority, when the Reserve Bank Act 1959 removed the central banking functions from the Commonwealth Bank to it....
from 1989–1996, raised this concern in 2008 in response to another hike in their interest rates.