What is Inflation Targeting?

Inflation targeting is a form of monetary policy where authorities set a target inflation rate and shape policy to match that rate. If inflation appears to be exceeding the rate, steps are taken to slow the rate of inflation, while if inflation is slowing, policymakers will take steps to increase the rate. The goal of inflation targeting is to keep an economy stable and developing steadily, avoiding runaway inflation or deflation. Many nations, including Australia and Greece, have adopted this approach, and in others, it is a topic of discussion and debate.

A common target is two percent. With inflation of two percent each year, the economy has room for growth but inflation is not out of control. Inflation over three percent or below one percent is generally a cause for concern. If the inflation rate starts creeping up, changes like increases in the lending rate can be made to force it back down. If inflation slows, slashing the lending rate will create more liquidity and cause inflation to rise.

Advocates for inflation targeting argue that it increases transparency of monetary policy. The target rate is published and available to all citizens, allowing people to see the decisions the government is making and to understand the policy changes used to support those decisions. People can also consider the policy when making economic decisions for themselves. For example, if a change in rate is anticipated, as these announcements usually occur on a regular basis, people can look at the inflation target and current rate of inflation to see if the rate will be higher or lower after the announcement.

Critics believe this type of fiscal policy can be too simplistic. Simply changing rates may not do enough to address developing inflation or deflation, especially when considered within the framework of a global economy. If some nations use inflation targeting and others do not, international trade can create problems as nations deal with mismatched economic policies while also attempting to maintain trade relations. Nations not using the policy can also potentially take advantage of favorable conditions in nations with inflation targeting.

Approaches to monetary policy are constantly evolving in response to new developments in economics, as well as the economy in general. Inflation targeting has waxed and waned in popularity at various points in time and around the world as people debate the best ways to keep economies healthy and stable while allowing for room to grow.