How Inflation Targeting Works

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

inflation rate targeting
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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%. On Aug. 27, 2020, the FOMC announced it will allow a target inflation rate of more than 2% if that will help ensure maximum employment. It still seeks a 2% inflation over time but is willing to allow higher rates if inflation has been low for a while.

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. Monetary policy tools, on the other hand, are slow-acting. It takes 18 to 24 months before an interest rate change impacts the economy. Central banks don't want to base slow-acting actions on indicators that move too quickly.

The Federal Reserve uses the Personal Consumption Expenditure price index to measure inflation. Before January 2012 it used the Consumer Price Index. The Fed believes the PCE index is a better gauge of inflation.

The Fed has targets for economic growth and unemployment rates as well. 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. After all, who wants higher prices? But a low and managed inflation rate is preferable to deflation. That's when prices fall. You'd think that would be a good thing. But people will 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. If there's enough growth, then demand outstrips supply. When prices rise, that's inflation.

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. 

If you had to choose between inflation and deflation, mild inflation is best.

The dangers of deflation are illustrated by the housing market collapse in 2006. As prices fell, homeowners lost equity and even the home itself. 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.

As this happened, 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 they think prices will always rise. Why? When shoppers expect prices to rise in the future, they will 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. In 1973, inflation went from 3.6% in January to 8.7% in December. 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. By January 1975, the Fed had lowered rates to 7.13 points. Inflation reached double-digits from February 1974 to April 1975.

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

In 2012, Federal Reserve Chairman Ben Bernanke introduced inflation targeting in the United States.

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

As prices rise, people buy more now because they want to avoid higher prices for consumer products. For investments, they buy now because they are confident it will give them a higher return when they sell later. If inflation targeting is done right, prices rise just enough to encourage people to buy sooner rather than later. 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 needed to 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 it experienced in the 1920s. Its success prompted other countries to use inflation targeting.

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

The Bottom Line

The Federal Reserve manages inflation with an inflation targeting policy. This monetary tool seeks that sweet spot of inflation at 2%. When prices rise at this ideal pace, it drives consumer demand. Shoppers buy now to avoid higher prices later. That boosts economic growth. When used with the Fed's other tools, inflation targeting also lowers the unemployment rate and keeps prices stable.

In order for inflation targeting to work, the Fed must clearly signal its intentions to raise or lower interest rates.

In the United States, inflation targeting has become an important monetary policy 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.