How Inflation Targeting Works

Inflation targeting can be a key factor in boosting the economy.

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Inflation targeting is a monetary policy where the central bank sets a specific inflation rate as its goal. The central bank does this to make you believe prices will continue rising. It spurs the economy by making you buy things now before they cost more.

Most central banks use an inflation target of 2%. The Federal Open Market Committee (FOMC) announced on August 27, 2020, that it would allow a target inflation rate of more than 2% if that would help ensure maximum employment. It still seeks a 2% inflation over time, but it's willing to allow higher rates if inflation has been low for a while.

Inflation targeting became an important monetary policy in the U.S. after the deflation that confounded the housing industry in 2008. That crisis could have led toward an economic collapse had the Fed not intervened with bailouts for the financial sector.

Key Takeaways

  • An inflation targeting policy is a monetary tool that seeks a sweet spot of inflation at 2%. It drives consumer demand when prices rise at this ideal pace.
  • It boosts economic growth when shoppers buy now to avoid higher prices later.
  • Inflation targeting also lowers the unemployment rate and keeps prices stable when it's used with the Fed's other tools.
  • The Fed must clearly signal its intentions to raise or lower interest rates in order for inflation targeting to work.

The Inflation Target and Core Inflation Rate

The inflation target applies to the core inflation rate. It takes out the effect of food and energy prices. These prices are volatile, swinging wildly from month to month. But monetary policy tools are slow-acting. Central banks don't want to base slow-acting actions on indicators that move too quickly.

The Federal Reserve uses the Personal Consumption Expenditure (PCE) price index to measure inflation because it gauges a wide range of household spending. In January 2012, the Fed first announced an explicit PCE target inflation rate, at 2%.

The Fed has projections for economic growth and unemployment rates as well, assuming appropriate monetary policy. The ideal GDP growth rate is between 2% and 3%. The natural rate of unemployment is between 3.5% and 4.5%.

How Inflation Targeting Works

Why would the Fed or any central bank want inflation? You'd think the economy would do better without any price increases whatsoever, but a low and managed inflation rate is preferable to deflation. That's when prices fall. People would put off purchasing homes, automobiles, and other big-ticket items if prices will be lower later.

The difficulty is in creating the right economic climate to create rising prices. That's where inflation targeting comes in. The federal government spurs economic growth by adding liquidity, credit, and jobs to the economy. Demand outstrips supply if there's enough growth. Inflation occurs when prices rise.

There are two ways to create growth. The Fed does it through expansionary monetary policy to lower interest rates. Congress does it with discretionary fiscal policy. That reduces taxes or increases spending. 

Mild inflation is best if you had to choose between inflation and deflation.

The dangers of deflation are illustrated by the housing market collapse in 2006. Homeowners lost equity and even their homes as prices fell. New potential buyers rented instead. They were afraid they would lose money on a home purchase. Everyone, including investors, waited for the housing market to recuperate.

The lack of demand forced housing prices into a downward spiral. Buyers didn't become confident in the housing market until they knew prices would go higher. That's the case for any other market where deflation has taken hold. 

Why Inflation Targeting Works

Inflation targeting works by training consumers to expect future higher prices. A healthy economy does better when people think prices will always rise. They'll buy more now while prices are still low. That "Buy more now" philosophy stimulates the demand needed to drive economic growth.

Inflation targeting is the antidote to the stop-go monetary policy of the past. Inflation went from 3.6% in January to 8.7% in December in 1973. The Fed responded by raising the fed funds rate from 5.94 points in January 1973 to 12.92 points by July 1974, but then politicians asked for lower interest rates. The Fed had lowered rates to 7.13 points by January 1975. Inflation reached double digits from February 1974 to April 1975.

The FOMC announced that it would again raise the federal funds rate by 25 basis points or .25% in March 2022.

The Fed confused price-setters about its policy by changing interest rates so much. Businesses were afraid to lower prices when the rate went down. They weren't sure the Fed wouldn't just turn around and raise rates again.

The 1970s experience taught Federal Reserve Chairman Ben Bernanke that managing inflation expectations was a critical factor in controlling inflation itself. It lets people know that the Fed will continue expansionary monetary policy until inflation reaches that 2% target.

People buy more as prices rise because they want to avoid even higher prices for consumer products later. They invest because they're confident that it will give them a higher return when they sell later. Prices rise just enough to encourage people to buy sooner rather than later when inflation targeting is done right. Inflation targeting works because it stimulates demand just enough.

How Inflation Targeting Began

Central banks in Germany and Switzerland first used inflation targeting in the mid-1970s. They had to do so after the Bretton Woods International Monetary System collapsed. The U.S. dollar value fell, sending other currencies higher. Germany has always been careful to avoid a recurrence of the hyperinflation that it experienced in the 1920s. Its success prompted other countries to use inflation targeting.

New Zealand, Canada, England, Sweden, and Australia adopted the policy in the 1990s. Many emerging market economies have also switched to inflation targeting since then: Brazil, Chile, Czech Republic, Hungary, Israel, Korea, Mexico, Poland, the Philippines, South Africa, and Thailand. No country that has adopted it has given it up. That's a testament to its success.

Frequently Asked Questions (FAQs)

How long does it take an interest rate change to affect the economy?

It takes 18 to 24 months before an interest rate change impacts the economy.

When did the U.S. begin using inflation targeting?

The U.S. first explicitly stated its intention to target 2% inflation in 2012. The U.S. also prioritizes maximum employment, which differs from some other countries that use inflation targeting.

Article Sources

  1. Federal Reserve Bank of Cleveland. "Why Does the Fed Care About Inflation?"

  2. Board of Governors of the Federal Reserve System. "Federal Open Market Committee Announces Approval of Updates to Its Statement on Longer-Run Goals and Monetary Policy Strategy."

  3. FRED. "Noncyclical Rate of Unemployment (NROU)."

  4. Board of Governors of the Federal Reserve System. "March 16, 2022: FOMC Projections Materials, Accessible Version."

  5. Federal Reserve Bank of St. Louis. "Effective Federal Funds Rate (FEDFUNDS)."

  6. U.S. Bureau of Labor Statistics. “Consumer Price Index Database, All Urban Consumers,” Select "U.S. city average, All items," "Retrieve Data," "More Formatting Options," "12-Month Percent Change," "1973 to 1975."

  7. Board of Governors of the Federal Reserve System. "Federal Reserve Issues FOMC Statement."

  8. Board of Governors of the Federal Reserve System. "Remarks by Governor Ben S. Bernanke."

  9. American Economic Association. "Inflation Targeting: A New Framework for Monetary Policy?," Page 103.

  10. Federal Reserve History. "The Smithsonian Agreement."

  11. International Monetary Fund. "Inflation Targeting: Holding the Line."

  12. Bank of Canada. "Monetary Policy: How It Works, and What It Takes."