What is Inflation Targeting?

target-marketFollowing almost two decades of high inflation in the 1970’s and 1980’s, inflation targeting was widely adopted by developed nations. Under inflation targeting, Central Banks are charged with using monetary policy to keep inflation close to a previously agreed level. This formal target sets out how much prices should rise each year. The goal of inflation targeting is to reduce inflation expectations and stave off high inflation.

Inflation targeting was initially introduced by New Zealand in 1989. The experiment was a success and brought inflation down from 7.2% to 2% within two short years. Canada, which was persistently struggling with high inflation, was the second country in the world to adopt inflation targeting. Most other developed nations followed suit soon after.

Ever since adopting inflation targeting, Canada has consistently had inflation below 3 per cent and has cut down the variability of CPI fluctuations by two thirds. Canada’s central bank is given an inflation target by the federal government approximately every five years. The target in Canada is based on the 12 month rate of change in consumer prices as measured by the consumer price index (CPI). The initial target was set in 1991 and aimed for inflation of 3 per cent. The target was later changed to 2 per cent in 1995 and has been renewed at that same level ever since.

How inflation targeting works

The central bank will publicly state the targeted inflation rate and then make efforts to guide the actual inflation rate in the direction of the target by using monetary tools available to it, such as interest rate changes.

If inflation is judged to be above the target, the central bank will often increase interest rates. Over time the effect of higher interest rates will likely result in a cooling of the economy by increasing savings and reducing spending, which in turn will bring down inflation.

On the other hand, if inflation is judged to be below the inflation target, the central bank will lower interest rates. The lower interest rates are likely to accelerate economic growth by causing more spending and less saving, leading to higher inflation.

An important factor in all of this is that the central bank is very open about what its goal is, which it does in the form of a stated target inflation rate, and about what it is willing to do to achieve that target. This creates a self-fulfilling prophecy as people and businesses will adjust their behavior towards the inflation target rate. If the central bank publicly states that it will use monetary tools to keep inflation low, people will likely have low inflation expectations.

Benefits of Inflation Targeting

Inflation targeting makes it easier to influence inflation as it changes the behavior of businesses and workers. For example, employees will demand lower salary increases if they expect low inflation than they would if they expected high inflation. If high inflation was expected, employees would demand higher salary increases and the higher salaries would in turn increase inflation by causing higher spending. Business, as well, would increases prices if they expected high inflation.

Having reliable expectations about future inflation allows people and businesses to plan better for the future. Stable inflation makes decision making easier. Investors and savers to not have to take fluctuating inflation into account when making long term investments. Business are able to make plan long term, invest, and do project cost-benefit analysis without having to create countless models with different inflation scenarios.

With inflation targeting, boom and bust cycles are smoothed out as variability in CPI fluctuations is lower. Before inflation targeting, there had been periods of high inflationary growth that later turned out to be unsustainable and led to recessions. Under inflation targeting, progress is usually more stable.

According to the International Monetary Fund, in emerging markets, inflation targeting appears to have been associated with lower inflation, lower inflation expectations and lower inflation volatility relative to countries that have not adopted it.

Disadvantages of Inflation Targeting

A common criticism of inflation targeting is that central banks become too focused on inflation and neglect other responsibilities, such as bolstering growth and reducing unemployment. High inflation can have disastrous consequences but so can an anemic economy and high unemployment. By committing to a specific inflation rate target, the central bank and the government put inflation control ahead of other goals and lose the flexibility to adjust policy as issues come up.

CountryYear adoptedTarget Rate or Band
New Zealand19891-3%
Canada19912% +/-1
United Kingdom19922%
Czech Republic19973% +/-1
Israel19972% +/-1
Poland19982.5% +/-1
Brazil19994.5% +/-1
Chile19993% +/-1
South Africa20003-6%
Hungary20013% +/-1
Mexico20013% +/-1
Iceland20012.5% +/-1.5
South Korea20013% +/-1
Norway20012.5% +/-1
Peru20022% +/-1
Phillipines20024% +/-1
Guatemala20055% +/-1
Indonesia20055% +/-1
Romania20053% +/-1
Turkey20065.5% +/-2
Armenia20064.5% +/-1.5
Ghana20078.5% +/-2
Albania20093% +/-1

Peter Fast

Peter Fast is a graduate of the University of Manitoba in Winnipeg, Canada, where he obtained a degree in Economics, specializing in Macroeconomic Trends in Canada. He subsequently worked in the finance industry for many years. His writing has been featured in several online and print financial publications.