Inflation is a persistent increase in the general level of prices of goods and services in an economy over a given period. Inflation targeting is a monetary policy strategy or action aimed at achieving a predetermined inflation rate. The target could be a single rate, a range, or an upper limit. The UK government set a target of 2% for the Bank of England. South Africa has a target of between 3% and 6%.
Inflation targeting is one of the actions or strategies taken by a central bank for the purpose of maintaining price stability. It uses different instruments to ensure that the pre-announced target is achieved. Other strategies adopted by monetary authorities include exchange rate targeting, interest rate targeting and monetary targeting.
The difference between the actual inflation rate and the predetermined target necessitates modification in order to achieve the set target. The target set by countries is always a low single-digit but not zero. This will create room for adjustments to be made to the policy in order to boost economic activities.
Instruments used for inflation targeting
This is the proportion of a bank’s deposits that must be kept in liquid assets. Liquid assets are assets that can be easily converted to cash when the need arises, e.g. cash, deposit with the central bank and government securities. The ratio can be raised by the central bank in order to reduce the inflation rate; there will be less money available for banks to give out, thereby reducing the volume of money in circulation.
Cash reserve ratio
The cash reserve ratio is the proportion of the bank’s deposits that is required to be held as reserves with the central bank. It can be raised in order to reduce the ability of the banks to grant more loans or lowered to increase the ability to grant credits to more customers.
Monetary policy rate
The rate at which the central bank lends to banks is the monetary policy rate. It determines the interest rates charged by other banks in the country. A rise is used to reduce the inflation rate while a fall is used to increase it.
Open market operation
It is the purchase and sale of securities such as bonds to influence the amount of money in circulation. Selling bonds reduces the money supply while buying increases the supply of money in the economy. Quantitative easing is a type of open market operation that is used to expand the money supply in economies with near-zero interest rates. It involves the purchase of securities by the central bank to boost economic activities.
The central bank can buy and sell foreign currencies as a way of intervention in the foreign exchange market. When it buys currencies, the exchange rate rises; selling foreign currencies reduces the value of the domestic currency. A lower exchange rate, for example, will boost net exports, and aggregate demand and increase the inflation rate.
Advantages of inflation targeting
The monetary authority becomes committed to achieving the target that has been announced. It will be dedicated work towards achieving it.
Formulation of policies
It serves as a guide to the monetary authority when formulating policies. Policies are usually designed to achieve the pre-determined target.
Appraising performance of monetary authority
The target is used to determine the effectiveness of government policies. The policies are deemed effective when the target is met; economic units may doubt the competence of a monetary authority if target is rarely met.
Communication of policy intentions to the public
The target is always made public and it indicates what the people and businesses should expect from the central bank.
Requirements for effective inflation targeting
Independence of the central bank
It must be able to design its policies without interference from the government. The central bank may find it difficult to raise interest when the government is highly indebted. Also, the government must not be too dependent on the central bank for financial support.
Developed financial market
A developed financial market will allow the central bank to use instruments such as open market operations to steer the inflation rate towards the pre-announced target.
Conflict with other policy objectives
There is often more than one policy objective such as exchange rate stability, economic growth and increased employment level. Another policy may be of more importance than price stability. The policy used to control inflation may make it difficult to achieve that other objective. For example, a contractionary policy used to reduce the inflation rate may increase unemployment.
Availability of reliable data
There is a need for timely and reliable data for the monetary authority to forecast inflation successfully. Without this, it would also be difficult to track prices and work towards achieving the target.