Inflation Targeting

Inflation targeting occurs when the central bank sets an explicit target for the inflation rate and sets monetary policy in order to hit that target.

Until January 2012, the Fed did not explicitly commit itself to achieving a particular inflation rate. However, in January 2012, the Fed announced that it would set its policy to maintain an approximately 2% inflation rate per year. With that statement, the Fed joined a number of other central banks that have explicit inflation targets. So rather than using a Taylor rule to set monetary policy, they instead announce the inflation rate that they want to achieve—the inflation target—and set policy in an attempt to hit that target. This method of setting monetary policy, called inflation targeting, involves having the central bank announce the inflation rate it is trying to achieve and set policy in an attempt to hit that target. The central bank of New Zealand, which was the first country to adopt inflation targeting, specified a range for that target of 1% to 3%.

Inflation Targets

This figure shows the target inflation rates of six central banks that have adopted inflation targeting. The central bank of New Zealand introduced inflation targeting in 1990. Today it has an inflation target range of from 1% to 3%. The central banks of Canada and Sweden have the same target range but also specify 2% as the precise target. The central banks of Britain and Norway have specific targets for inflation, 2% and 2.5%, respectively. Neither states by how much they’re prepared to miss those targets. Since 2012, the U.S. Federal Reserve also targets inflation at 2%.

In practice, these differences in detail don’t seem to lead to any significant difference in results. New Zealand aims for the middle of its range, at 2% inflation; Britain, Norway, and the United States allow themselves considerable wiggle room around their target inflation rates.

Other central banks commit themselves to achieving a specific number. For example, the Bank of England has committed to keeping inflation at 2%. In practice, there doesn’t seem to be much difference between these versions: central banks with a target range for inflation seem to aim for the middle of that range, and central banks with a fixed target tend to give themselves considerable wiggle room.

One major difference between inflation targeting and the Taylor rule method is that inflation targeting is forward-looking rather than backward-looking. That is, the Taylor rule method adjusts monetary policy in response to past inflation, but inflation targeting is based on a forecast of future inflation.

Advocates of inflation targeting argue that it has two key advantages over a Taylor rule: transparency and accountability. First, economic uncertainty is reduced because the central bank’s plan is transparent: the public knows the objective of an inflation-targeting central bank. Second, the central bank’s success can be judged by seeing how closely actual inflation rates have matched the inflation target, making central bankers accountable.

Critics of inflation targeting argue that it’s too restrictive because there are times when other concerns—like the stability of the financial system—should take priority over achieving any particular inflation rate. Indeed, in late 2007 and early 2008 the Fed cut interest rates much more than either a Taylor rule or inflation targeting would have dictated because it feared that turmoil in the financial markets would lead to a major recession. (In fact, it did.)

Many American macroeconomists have had positive things to say about inflation targeting—including Ben Bernanke (the previous chairman of the Fed). And in January 2012 the Fed declared that what it means by the “price stability” it seeks is 2% inflation, although there was no explicit commitment about when this inflation rate would be achieved.