By Aniket Bose. Edited By Arjun Chandrasekar
Inflation targeting is a central banking policy that revolves around the adjustment of the monetary policy for achieving a specific annual rate of inflation. The principle behind inflation targeting is based upon the belief that the best way to achieve long-term economic growth by maintaining price stability and achieving price stability is to control inflation.
Understanding Inflation Targeting
As a strategy, inflation targeting views the primary goal of the central bank being able to maintain price stability. All of the tools of monetary policy that a central bank has in place, including open market operations and discount lending, can be employed as a general strategy of inflation targeting. Inflation targeting can also be contrasted with other strategies used at central banks aimed at other measures of economic performance as their primary goals, such as targeting the unemployment rate, currency exchange rates, or even the rate of nominal Gross Domestic Product (GDP) growth.
Interest rates can be used as an immediate target by central banks in inflation targeting. Central banks will either lower or raise their interest rates based upon whether they think inflation is above or below a target threshold set by the central bank. Raising interest rates has been said to slow inflation, which also leads to slow growth in the economy. Lowering interest rates is believed to boost inflation and speeding up economic growth, in the process. The benchmark that is used for inflation targeting is typically a price index of a basket of consumer goods, such as the Personal Consumption Experience that is used by the U.S. Federal Reserve. Along with taking inflation target rates and setting calendar dates as performance measuring tools, inflation targeting policy may also have established steps that are to be taken depending on how much the actual inflation rate varies from the targeted value, by cutting lending rates or adding liquidity to the economy.
Inflation targeting allows central banks to respond to shows from the domestic economy and strictly focus on domestic considerations. Stable inflation reduces the uncertainty of an investor, allows investors to predict changes in interest rates, and anchors expectations of inflation. If the target is announced, inflation targeting also allows for there to be greater transparency in monetary policy. However, there are some analysts that believe that central banks should be focused on inflation targeting for price stability where it creates an atmosphere in which unsustainable speculative bubbles and other lies in the economy can thrive without being checked.