Inflation targeting

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.^[1]

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) and its members, regularly publicly state a desired target range for inflation (usually 1.7%-2%), but do not have an explicit inflation target. In a historic shift on January 25, 2012 Chairman Ben Bernanke set a 2% target inflation rate which brings the Fed in line with many of the world's other major central banks.

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, former Governor of the Bank of England, had in 1997 colorfully termed "inflation nutters"^[2] - 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 ^[3] and asserts that the buffoonery 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.^[4]

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.^[5]

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 Fisher 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,^[6] 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.^[7]

Shortcomings

Increases in inflation (CPI) are not necessarily coupled to any factor internal to a country's economy and 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 Australia from 1989–1996, raised this concern in 2008 in response to another hike in their interest rates.^{[11][citation needed]}

Supporters of a nominal income target criticize the propensity of inflation targeting to neglect output shocks by focusing solely on the price level. Adherents of market monetarism, led by Scott Sumner, argue that in the United States, the Federal Reserve's mandate is to stabilize both output and the price level, and that consequently a nominal income target would better suit the Fed's mandate. Australian economist John Quiggin, who has endorsed nominal income targeting, has stated that "A system of nominal GDP targeting would maintain or enhance the transparency associated with a system based on stated targets, while restoring the balance missing from a monetary policy based solely on the goal of price stability."^[12] Quiggin blamed the late-2000s recession on inflation targeting, saying:

Inflation targeting led central bankers, most notably Alan Greenspan of the US Fed, to ignore or even applaud the unsustainable bubbles in speculative real estate that produced the crisis, and to react too slowly as the evidence emerged. Worse still, in the post-crisis environment, achievement of inflation targets has no longer promoted stable economic growth. Rather, low inflation has been a drag on growth. But with inflation clearly under control, central bankers like former European Central Bank President Jean-Claude Trichet have been able to describe their own performance as ‘impeccable’, even as the economies and currencies they manage appear headed for collapse.^[12]

In an op-ed in 2012, Harvard University economist Jeffrey Frankel suggested that inflation targeting "evidently passed away in September 2008," referencing the 2007–2012 global financial crisis. Frankel suggested "that central banks that had been relying on [inflation targeting] had not paid enough attention to asset-price bubbles," and also criticized inflation targeting for "inappropriate responses to supply shocks and terms-of-trade shocks." In turn, Frankel suggested that nominal income targeting or product-price targeting would succeed inflation targeting as the dominant monetary policy regime.^[13]

Variations

Contrast to the usual inflation rate targeting, Laurence Ball proposed targeting on long run inflation, targeting which takes the exchange rate into account^[14] and monetary condition index targeting. In his proposal, the monetary condition index is a weighted average of interest rate and exchange rate. It will be easy to put many other things into this monetary condition index.

See also

• Monetary policy
• Taylor rule
• Phillips curve
• Inflationism
• Nominal income target

References

External links

• Table of Central Bank Inflation Targets
•  Irving Fisher (1922). "Dollar Stabilization". Encyclopædia Britannica (12th ed.). 

Further reading

• Acocella, N., Di Bartolomeo, G. and Tirelli, P. [2012], ‘Inflation targets and endogenous markups in a New Keynesian model’, in: ‘Journal of Macroeconomics’, 391-403.