Central Bank Independence: Inflation Targeting

By: Peter Ort The Quinnipiac University Global Economics Research Team 

Photo credits: Etienne Martin on Unsplash

This is the first article in our four-part series on Central Bank Independence and focuses on inflation targeting, an innovation in central banking that emerged in the 1990s and remains important to understanding central banking today.

The term “inflation targeting” was coined in 1990 by the Central Bank of New Zealand, the first central bank to adopt an inflation targeting regime.  Inflation targeting eventually spread to the rest of the world due to its reliability and flexibility.

Inflation targeting begins with the central bank setting an inflation goal for itself, usually being around 2-2.5%. The inflation target would be aimed at via the actions of the central bank (such as open market operations or adjusting interest rates) while the actual inflation rate would be stabilized by the market, so long as it had confidence in the central bank. Therefore, inflation targeting worked very effectively in developed and economically sound countries like Germany and Switzerland which had a long history of credibly fighting inflation.

With inflation targeting, there are two different ways central banks approach it: following a set rule or discretionarily. Inflation targeting as a rule refers to central banks strictly controlling for inflation, while discretion alludes to changing inflation rates depending on the given situation, often without a target in the first place. People often view inflation targeting as strictly a rule, which is only part of the formula. Although central banks try to control inflation and set a target, they do not simply ignore other parts of the economy due to being an inflation targeting regime. Inflation targeting is better understood as being a hybrid of both, but more so discretion. Central banks do set inflation targets, but they make sure to not keep the target too rigid so that they can potentially adjust for shocks or policy.

Many have criticized central banks for focusing too much on inflation, as they believe other parts of the economy should be treated similarly by the fed. As discussed by Ben Bernanke, former chairman of the Federal Reserve (2006-2014), central banks have over time concluded that targeting for inflation changes the economy in the long run, while trying to adjust strictly for other parts amounts to no significant changes in the long run, a phenomenon known as money neutrality (i.e., money has no – or a neutral – effect on real aspects of the economy in the long run).

In later articles, we will discuss the relationship between inflation targeting and central bank independence, and ultimately why it matters.

Source:

Bernanke, B. S., & Mishkin, F. S. (1997). Inflation targeting: A new framework for monetary policy? Journal of Economic Perspectives, 11(2), 97–116. https://doi.org/10.1257/jep.11.2.97