Inflation targeting

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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.

Example A) 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.

Example B) 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 inflation targeting, 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.

Inflation targeting is in use by the United Kingdom, Australia, South Korea, South Africa and Brazil, among other countries, and there is some empirical evidence that it does what its advocates claim. [1]

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 around 1.5-2%), 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 (Governor of the Bank of England) termed "inflation nutters"^[1] - that is, central bankers who concentrate on the inflation target to the detriment of stable growth, employment and/or exchange rates. However, as King notes, this has certainly not happened in 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; current Chairman Ben Bernanke, however, is a well-known advocate of inflation targeting.^[2]

[edit] References

1. ^ As quoted on page 158 of Poole, W. (2006), ‘Inflation targeting,’ speech delivered to Junior Achievement of Arkansas, Inc., Little Rock, Arkansas, 16th February 2006. Published in Federal Reserve Bank of St. Louis Review, vol. 88, no. 3 (May-June 2006), pp. 155-164.
2. ^ See his many published works on the subject, for example: Bernanke, B. S. and Mishkin, F. S. (1997), ‘Inflation targeting: a new framework for monetary policy?’ in The Journal of Economic Perspectives, vol. 11, no. 2 (Spring 1997), pp. 97-116.