Inflation target - The level around which the central bank undertakes to stabilize inflation.
The central bank's inflation target - Central banks have adopted many different approaches to monetary policy in recent decades. The range of applied solutions ranges from highly discretionary (discretionary) approaches that coordinate monetary and fiscal policy under the direction of the government to highly automated approaches, with target targets for money supply or bank reserves.
Determining the inflation target
It depends on the announcement of an official target range for the inflation rate and a clear declaration that low and stable inflation is the overriding objective of monetary policy. This approach in hard or soft variety has been adopted in recent years by many industrialized countries, including Canada, Great Britain, Australia and New Zealand, and in indirect form through Germany. The Treaty introducing a new European currency for the euro requires the European Central Bank to take care of price stability as a primary goal.
Inflation target strategy
The inflation target is characteristic of the central bank's goal of not stabilizing prices (zero inflation), but stabilizing inflation at a certain level, for example 2%. One of the reasons for this is that low inflation is conducive to stable economic growth, but central banks become "nervous" when the likelihood of deflation increases (domestic prices decline). The central bank may react effectively to rising inflation by raising the interest rate. Deflation is worse. It may turn out that the central bank will not be able to effectively counter the growth of real interest rates (due to the fall in domestic prices), because it can lower interest rates "only" to zero.
Therefore, central banks react nervously to the risk of deflation entering the economy. They do what is in their situation. They strongly reduce the interest rate and "pump" liquid reserves to commercial banks, so that they increase the supply of cheap credit. It happens that they do it quickly and on a large rock. They know that they can not make it before deflation. By setting the inflationary target at a "remote" level from zero, central banks create a safety margin that deflation does not surprise them.
Central banks do not undertake that inflation will remain at the target level all the time. They commit to bring it back to the target after a certain period of time if it increases or decreases. This is because central banks do not want inflation stabilization to cause too high fluctuations in the rate of economic growth.
The manner of conducting monetary policy by central banks is described by Taylor's rule. It assumes that central banks react by changing the interest rates to deviations of inflation from the set target and to deviations of the rate of economic growth from the potential rate:
IBC = iR + γ1 + πi (πi-π *) + γ2 (y-y *),
iBC - central bank rate, iR - the amount of the real provisional rate, πi - inflation (expected), π * - inflation target, yi - the rate of economic growth, y * - potential growth rate. Empirical studies indicate that the estimation of relative weights (1, 2) that a given central bank applies to stabilize inflation and growth rate, allows predicting (with more or less strictly) its decisions regarding changes in interest rates.
Procedures related to the adoption of the inflation target include the following activities.
The government or the central bank announces that monetary policy will strive to keep inflation close to a certain size. This size is usually defined as a range, e.g. 1-3% per year, and not as literal price stability. In general, the government's goal coincides with the so-called inertial inflation rate (core), expressed in the consumer price index, omitting prices of food and energy products, characterized by high volatility, and excluding taxes increasing prices. Inflation is the main, overarching policy goal in the medium and long term. Countries that have adopted this approach, however, always leave some room for short-term stabilization goals, in particular with regard to production, unemployment, the sustainability of public finances and the exchange rate. These short-term objectives take into account the possible impact of supply shocks on output and unemployment, and therefore a temporary departure from the inflation target to avoid excessive unemployment or losses in production may be desirable. Neutral inflation as the basis of the central bank's policy Observation of the correlation between the rate of price increase and economic growth both in the industrialized countries and in countries with the most dynamic economies, allows to put forward the thesis that economic policy based on strict inflation control in order to maintain it at a pre-established low level does not create good conditions for long-term, stable economic growth and must be replaced by a completely different theoretical approach, more friendly to economic growth. An alternative model for determining the inflation target by the central bank could be based on the neutral inflation hypothesis or the Non-Decreasing Economic Growth Rate of Inflation (NDEGRI), understood as an average - within 5-10 years - a price increase that coexists with the highest rates of economic growth, at which inflation expectations are stable (ie inflation does not tend to accelerate).
- Ireland, P. N. (2007). Changes in the Federal Reserve's inflation target: Causes and consequences. Journal of Money, credit and Banking, 39(8), 1851-1882.
- Eichengreen, B. (2013). Can emerging markets ﬂoat? Should they inﬂation target?. Exchange rates, capital flows and policy, 10.
- Siklos, P. L. (1998). Inflation target design, changing inflation performance and persistence in industrial countries. Changing Inflation Performance and Persistence in Industrial Countries (November 1998).