Why Do Central Banks Target Inflation?

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Inflation target

When it comes to determining monetary policy, among a number of economic indicators that policymakers look at, one particular indicator stands out. Inflation or consumer price index has been one of the key factors when it comes to central bank policy responses.

If one looks back to the time since the 2008 global financial crisis, central banks have pumped trillions of dollars into the economy. This monetary policy response, dubbed Quantitative Easing initially evoked a lot of doubt among skeptics. Some even went as far as to question how long such a policy response would go.

However, the central bank’s QE policies have managed to revive the economy to a certain extent. Among the factors that the central bank considers, inflation ranks high. Interestingly though, inflation is not a standalone indicator and is in fact influenced by other components.

For example, the unemployment rate or the labor market plays a key role. If wages do not rise, how can consumers spend more? And when consumers do not spend more, how can inflation rise?

As you can see from the above, inflation although looks like a standalone indicator or a metric for the central bank takes into account the broader market.

 

2008_Financial crisis

What is the inflation targeting mandate?

Inflation targeting mandate is also known as a monetary policy regime. Here, the central bank sets an explicit target for the inflation rate in the short to medium term. It is widely publicized as well. A quick look at various central bank monetary policy statements will show the various inflation targets set by the respective central banks.

In the advanced economies, central banks follow a 2% inflation target rate. Examples include the United States Federal Reserve, the European Central bank and the Bank of England to name a few.

Other central banks set a target band to allow for more policy flexibility. For example, the Reserve Bank of Australia follows an inflation target band of 2% – 3%, while the Reserve Bank of New Zealand follows an inflation band of 1% – 3%.

Inflation or price stability is of importance to the central banks as they believe that maintaining the stability of prices is essential to the growth of an economy.

Based on how inflation fluctuates, central banks use this to respond to monetary policy. Raising interest rates is said to contain rising inflation and cools down the economy from overheating. Conversely, cutting interest rates is said to support an increase in inflation in an effort to kick-start the economy.

These cycles of policy tightening and easing are all based on inflation.

The inflation targeting regime was proposed by John Maynard Keynes.

Keynes recommended that exchange rate flexibility was needed as a response to inflation.

Prior to inflation targeting, central banks used to directly set the currency peg. However, it is public knowledge how especially in recent times central banks have failed to maintain the peg.

Swiss Franc – Anatomy of a Crisis

Examples include the Central Bank of Russia which eventually gave up defending the currency during the height of the Ukraine crisis. We also know about the Swiss National Bank eventually giving up the peg that it defended for years.

The RBNZ was among the first central banks in the world to shift to an inflation targeting regime in 1989.

 

Can the central banks manage to reach the inflation target?

After the 2008 financial crisis, central banks lowered interest rates and also started to pump money into the economy. This came at a time when inflation remained subdued across the globe. However, in recent times, inflation has started to pick up, most notably in the Eurozone.

For central banks, inflation targeting doesn’t mean raising rates when inflation reaches 2%, but rather monitoring the trends in inflation. Thus, when inflation starts to show a steady uptrend and edges closer to the inflation target rate, central bankers start to hike rates gradually as well.

For traders, inflation is often seen as a binary event for trading. While this might be true in the short term, understanding the inflation targeting regime can help traders to better speculate the potential central bank policy responses.

The currency markets revolve around interest rates, and the interest rates are set as a result of inflation.

 

 

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John has over 8 years of experience specializing in the currency markets, tracking the macroeconomic and geopolitical developments shaping the financial markets. John applies a mix of fundamental and technical analysis and has a special interest in inter-market analysis and global politics.

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