Inflation Targeting

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21 Aug, 2024

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Inflation targeting is a policy measure that controls the flow of money or money supply in an economy. Thus, monetary policy is a tool of the central bank or federal reserve in the U.S to mitigate inflation rates annually or quarterly to ensure price stability and economic growth.

Inflation targeting policy helps maintain price stability, and affordable prices enable an economy to become competitive and efficient in producing goods and services. This targeting assists long-term and sustainable economic growth and development, especially for developing countries. As a result, an economy can increase its GDP or output levels and ensure low unemployment levels.

What is Inflation Targeting?

Inflation targeting is a method of controlling the rising prices in an economy. It explains the two ultimate goals of the central bank's monetary policy: to maintain price stability and ensure economic growth.
An increase in inflation results from various factors such as supply shortage, fiscal stimulus by governments, or external shocks. However, the central bank uses quantitative tightening to limit the excess liquidity or money supply in the economy that gives rise to excess demand.
Thus, inflation targeting enables price stability and ensures economic growth, low unemployment levels, and more exports by stabilizing the currency exchange rate.

Inflation Targeting Explained

Inflation targeting explains the central banking policy that fixes a threshold or inflation target, and monetary policy helps achieve it. In addition, the regulation of monetary policy enables the central bank to control the financial system of a country or jurisdiction.

The inflation targeting framework involves maintaining a stable inflation rate that enables economic growth and stability. Thus, the central bank uses policies such as open market operations and offers commercial banks discounted loans to maintain low and stable inflation. As a result, interest rates become a means for central banks to regulate the inflation rate.

For instance, interest rates assist the central bank in controlling inflation by regulating the flow of credit by commercial banks, thereby influencing the money supply.

To tame the high inflation rate, a central bank will increase the lending rate to commercial banks. Consequently, commercial banks pass these on to the general public while facilitating loans. As a result, it reduces the money supply, limits consumer spending, controls inflation, and slows economic growth. Thus, such quantitative tightening of the money supply explains inflation targeting meaning.

Similarly, a lower interest rate boosts economic activities and accelerates economic growth. As a result, commercial banks offer the general public low-cost credit, which leads to greater investment and consumption levels. The low-cost availability of credit also results in prosperous business cycles. It encourages businesses to produce more and invest in research and development as demand increases.

Analysts determine changes in inflation by considering a basket of goods. These include food, electronics, apparel, housing, fuel, education, medical care, etc. Thus, price changes help determine the increase or decrease in the inflation rate and assist in calculating the price index.

All about Inflation - Explained in Video

Effects

Inflation targeting controls the inflation rate by adjusting the central bank's monetary policy. An inflationary situation occurs in an economy due to a general increase in the price level of goods and services. It is an outcome of increased liquidity or money supply. Thus, the monetary policy is a tool in the hands of the central bank to tighten the flow of money or interest rates.

The central bank will use quantitative measures such as targeting interest rates. Thus, the cash reserves of commercial banks will increase to control the soaring inflation. However, increasing the interest rates will lower the pace of economic activities, which might also lead to increasing unemployment.

Although, targeting does not correct the supply chain constraints. In such a scenario, the government authorities or private stakeholders must ensure that supply meets demand to restrict price rise.

Similarly, in the case of inflation targeting, the central banks aim to stabilize the currency exchange rate by maintaining a reserve of domestic currency and most tradable currencies. While injecting money to correct inflationary pressures, it aims to stabilize the appreciating domestic currency and establish the market equilibrium of the exchange rate.

Example

For instance, the consumer price index (CPI) for the U.S economy has risen to a four-decade high at 9.1% in a matter of 12 months. The U.S. Bureau of Labour Statistics reported this percentage in June 2022 to establish that this cap on the rate of inflation was due to a continuous rise in price levels over months.

Federal Reserve established the inflation target for the long-term period at 2%. The inflation targeting by the Fed was a measure of the personal consumption price index or PCE index. This index helps the Fed to calculate the rising inflation and trends in consumer spending in the U.S. economy. Thus, the Fed continuously adjusts its monetary policy to keep the PCE index growth around 2%.

In 2020, the Fed slashed the interest rates to zero to stimulate consumers and help businesses recover from covid-19 induced shocks. Further, to target the high and rising inflation rate of 4.2% in April 2021, the highest in 13 years, the Fed started to increase interest rates for both the short and long term.

However, the COVID-19 pandemic-induced inflationary pressures and rising prices due to supply shortages, fiscal stimulus, and other global factors such as Russian-Ukraine that skyrocketed food prices have led to continuous shocks to the U.S. economy. Thus, to target rising inflation, the U.S. Federal Reserve increased the interest rates four times in 2022.

The increase in interest rates aims to stimulate the overheating economy and tighten the money supply by pulling out the money from the economy. However, some experts fear that the fed inflation targeting and quantitative tightening might also be a recipe for a economic recession or slowing economic growth.

Advantages & Disadvantages

Let us now look at some of the advantages and disadvantages of inflation targeting to understand the topic comprehensively,

Advantages	Disadvantages
Stabilizes the rate of inflation and cools the overheating economy.	Gives rise to speculative behavior due to external shocks; thus, targeting cannot stabilize exchange rates in the short run.
Enables businesses, investors, and the government to plan their investments and policies by considering inflation rate changes.	It puts too much focus on the price levels and money supply-related goals and might ignore other goals of economic growth or unemployment.
It helps maintain a transparent monetary policy.	Does not remove supply bottlenecks or shortages.
Targeting enables increased economic stability.	Inflation targeting may limit policy flexibility or constrain policy measures such as fiscal stimulus.

Inflation Targeting vs Monetary Targeting

Targeting inflation implies controlling the changes in the general price levels of an economy by the central bank. On the other hand, monetary targeting is a way to manage the monetary aggregates, i.e., the total amount of money circulating in the economy. Therefore, it does not particularly focus on the inflation rate but aims to control the money supply within the economy.

However, monetary targeting indirectly controls the inflation rate by controlling the money supply. Similarly, stabilizing the currency exchange rate is an intermediary in the central bank's monetary targeting process. It requires maintaining forex reserves with the central bank and injecting domestic currency into the market when required.

A monetary policy also focuses on money markets wherein large transactions occur between financial institutions and governments or companies. As a result, money multiplies and grows through credit generation. Thereby, the central bank focuses on controlling the growth of money, which is also an intermediate to the monetary policy objective of a low and stable inflation rate.

Frequently Asked Questions (FAQs)

1. What is flexible inflation targeting?

It means that central banks aim to maintain the inflation rate within a range but ensure that inflation floats closer to the target. This flexible targeting also enables economic growth by not strictly maintaining the inflation rate but allowing it to float.

2. Why inflation targeting is important?

It is important to manage the supply and growth of money in an economy to restrict too much liquidity in the hands of the general public. The problem of excess demand and low supply occurs due to scarcity of resources. Thus, it leads to too much money running after too few goods, which increases the general price level. Further, it increases costs for businesses, governments, and consumers, restricting output and consumption levels. Thereby it promotes economic growth, keeps unemployment low, and encourages exports.

3. What are the two potential drawbacks of inflation targeting?

Firstly, inflation targeting puts too much pressure on inflation-related goals and ignores other important objectives such as economic growth and low unemployment. Secondly, inflation targeting restricts policy measures such as subsidies or other types of fiscal stimulus, which target certain marginalized sections of the society to survive crisis-like situations.