Inflation Targeting

Inflation targeting is a common practice among central banks globally that aims to influence the level of prices in an economy through the use of several monetary policy tools.

Inflation targeting is a monetary policy where a central bank follows an explicit target for the inflation rate for the medium-term and announces this inflation target to the public. The assumption is that the best that monetary policy can do to support long-term growth of the economy is to maintain price stability, and price stability is achieved by controlling inflation. The central bank uses interest rates, its main short-term monetary instrument.

An inflation-targeting central bank will raise or lower interest rates based on above-target or below-target inflation, respectively. The conventional wisdom is that raising interest rates usually cools the economy to rein in inflation; lowering interest rates usually accelerates the economy, thereby boosting inflation. The first three countries to implement fully-fledged inflation targeting were New Zealand, Canada and the United Kingdom in the early 1990s, although Germany had adopted many elements of inflation targeting earlier.

Inflation Targeting in India

Inflation forecasts are crucial for the conduct of forward-looking monetary policy, and they play a special role in the inflation targeting framework by acting as an intermediate target. Hence, the significance of accurate forecasts can scarcely be exaggerated. In India, the Reserve Bank of India undertook inflation targeting in August 2016. The decision was taken after India had ~10% inflation rate for around five years.

The amendment to Reserve Bank of India Act, 1934, effective in June 2016, made way for a Flexible Inflation Targeting (FIT) framework in India by defining the primary objective of monetary policy as maintaining price stability together with the objective of growth.

To operationalise this command, the Government of India notified a medium-term inflation target of 4%, with a band of +/- 2% between August 2016 and March 2021. The inflation target is fixed in terms of all-India CPI-Combined issued by the Central Statistics Office (CSO).

Key Factors

In order to properly and successfully pursue its inflation targeting goal, a central bank must possess three important characteristics, independence, credibility, and transparency.

1. Central bank independence

If central banks are not independent, monetary policies may be influenced by short-term political interests that can be inconsistent with the inflation goals. For example, politicians may try to stimulate the economy with several monetary tools hoping for reelection, which can lead to higher inflation and failure in reaching the inflation targets previously set.

That’s why it’s a common belief that central banks should remain operationally independent. Moreover, some central banks also target independence, which means they set their own inflation targets.

2. Central bank’s credibility

In some cases, inflation targets may be inconsistent with other macroeconomic conditions. For example, a heavily indebted country that is aiming for a very low level of inflation may not be credible, as it could be in the government’s interest to resort to a higher inflation rate to dilute the real value of debt.

3. Central bank’s transparency

The concept of transparency is connected to that of credibility. A central bank that is not transparent in its decisions will ultimately lose credibility. That’s why many central banks produce quarterly reports, where they discuss the state of the economy and the trends in variables, such as money supply, securities markets, gross domestic product (GDP), employment, and prices.

4. Self-fulfillment of inflation-targeting policies

In some cases, inflation targeting measured by credible entities may be self-fulfilling. If people believe that the central bank will reach its inflation target, they start to act accordingly. For example, workers may require wage increases, at least in line with the expected inflation target, which will ultimately lead inflation towards that level.