What Is Inflation Targeting, and How Does It Work?

What Is Inflation Targeting?

Inflation targeting is a central banking policy that revolves around adjusting monetary policy to achieve a specified annual rate of inflation. This is known as the target rate, which is normally set at around 2% to 3%.

The principle of inflation targeting is based on the belief that long-term economic growth is best achieved by maintaining price stability, and price stability is achieved by controlling inflation.

Inflation targeting can be compared with other central bank operating targets, such as price level targeting and nominal gross domestic product (GDP) targeting.

Understanding Inflation Targeting

As a strategy, inflation targeting views the primary goal of the central bank as maintaining price stability. All of the tools of monetary policy that a central bank has—including open market operations (OMOs) and discount lending—can be employed in a general strategy of inflation targeting. Inflation targeting can be contrasted to strategies of central banks aimed at other measures of economic performance as their primary goals, such as targeting currency exchange rates, the unemployment rate, or the rate of nominal GDP growth.

Interest rates can be an intermediate target that central banks use in inflation targeting. The central bank will lower or raise interest rates based on whether it thinks inflation is below or above a target threshold. Raising interest rates is said to slow inflation and therefore slow economic growth. Lowering interest rates is believed to boost inflation and speed up economic growth.

The benchmark used for inflation targeting is typically a price index of a basket of consumer goods, such as the Consumer Price Index (CPI) or the Personal Consumption Expenditures (PCE) Price Index, which is now used by the U.S. Federal Reserve.

Along with taking inflation target rates and calendar dates as performance measures, inflation-targeting policy may also have established steps that are to be taken depending on how much the actual inflation rate varies from the targeted level, such as cutting lending rates or adding liquidity to the economy.

Pros and Cons of Inflation Targeting

Inflation targeting allows central banks to respond to shocks to the domestic economy and focus on domestic considerations. Stable inflation reduces investor uncertainty, allows investors to predict changes in interest rates, and anchors inflation expectations. If the target is published, inflation targeting also allows for greater transparency in monetary policy.

However, some analysts believe that a focus on inflation targeting for price stability creates an atmosphere in which unsustainable speculative bubbles and other distortions in the economy, such as that which produced the 2008 financial crisis, can thrive unchecked (at least until inflation trickles down from asset prices into retail consumer prices).

Other critics of inflation targeting believe that it encourages inadequate responses to terms-of-trade shocks or supply shocks. Critics argue that exchange rate targeting or nominal GDP targeting would create more economic stability.

The Bottom Line

Inflation targeting is a goals-based approach to monetary policy whereby a central bank seeks a specific annual rate of inflation for a country’s economy (normally around 2% or 3% per year). The central bank can then use a range of policy measures, such as setting interest rates or open market operations (OMOs), to maintain that target.

Research suggests that economies become more resilient and prices more stable once inflation targeting has been adopted, although some economists critique the measure as ineffective—for instance, in the decade following the 2008 financial crisis, when inflation remained well below the target rate in many countries for years. More recently, inflation has surged above the target rate around the globe in 2022.