Inflation Targeting

Introduction

Most of the world's Central Banks have among their attributions that of guaranteeing or at least pursuing price stability. This does not imply that no price should ever move even a little bit, but rather that no disruptive episodes should occur that could lead to unbearable instability. One of the monetary policies that has gained more weight since the beginning of the 21st century is that of “Inflation Targeting”. To understand why a country might want to have “some” inflation, we recommend an in-depth look at the essays on “interest rates” and Philips Curve”.

What is it?

Just as an advertising agency “targets” its campaigns to think about the audience it wants to reach, a basketball team sets a “target” of victories to try to get into the PlayOffs; a sharpshooter sets his “target” in the central circle that gives the highest score, the Central Bank can also define what its inflation target will be.

According to the IMF, in the Inflation Targeting scheme, the Central Bank estimates (and publishes!) a projected inflation target rate, and describes the tools with which it will try to bring current inflation to the target rate. Generally, the most frequently used tool in this scheme is to move the reference interest rate, although more heterodox programs may include other complements such as price and wage agreements, or a more interventionist exchange rate policy.

The inflation targeting scheme seeks to have an impact mainly on a determining factor in the nominal nature of an economy: expectations. By defining and making public a target inflation number, it sets a clear path for all agents that have to define a price in the economy. In this way, it is expected that most prices will follow or approach the target described by the monetary authority, unless some particular phenomenon produces changes in relative prices (such as a particular shortage of an input in a certain activity, or an excessive demand in the ice cream market during the summer).

How do they actually work?

Some countries have chosen inflation targets with symmetric ranges around a midpoint, while others have only identified a target rate or an upper limit for inflation.

Most countries have set their inflation targets in the low single digits.

One of the main advantages of inflation targeting is that it combines elements of both "rules" and "discretion" in monetary policy.

In any case, it should be noted that inflation targeting schemes generally pursue medium-term objectives, so that some discretion is allowed to achieve secondary objectives in the short term (such as stimulating economic growth, or resolving a balance of payments crisis).

Necessary points of Inflation Targeting:

1. A Central Bank independent enough to conduct monetary policy (not subordinate to fiscal policy)

2. The ability and determination to prioritize inflation as the main indicator to be followed, leaving all others in the background (wages, employment, exchange rate).

Frequent points in Inflation Targeting schemes according to the IMF:

• Set explicit quantitative inflation targets for a given number of future periods.

• Clearly and unambiguously indicate to the public that the achievement of the inflation target has priority over all other monetary policy objectives.

• Establish an inflation forecasting model or methodology that uses a series of indicators containing information on future inflation.

• Develop a forward-looking operational procedure by which monetary policy instruments are adjusted (based on the assessment of future inflation) to achieve the chosen objective.