The central banks make forecasts of future inflation rates then compare them to the standards they consider to appropriate for the current economy. The difference between the two rates determines how to adjust the monetary policy to maintain price stability; this strategy is called inflation targeting.
Inflation targeting was initially adopted in New Zealand in 1988 and has been implemented in over thirty economies across the globe.
Benefits of Inflation Targeting
Managing expectations. Central Banks aim to keep inflation rates below the 2%-3% threshold. That way, the households, and businesses tend to have lower inflation expectations, which instills predictability in the microenvironments. Predictability is essential for the economy because it imparts a form of normalcy Businesses are made aware of the costs they will incur, and households can organize their incomes within the set targets (Bléjer, 2000).
- Maintaining sustainable growth. Inflation targeting has been used to cushion economies against adverse economic cycles like the boom and bust. Such bubbles in the marketplace make a shift in the equilibrium between demand and supply, and inflation targeting helps avoid the unsubstantiated growth patterns that lead to recession. Economic agents can use data on how the monetary policy administered to evaluate the performance of the Central Banks.
- Preventing a collapse. Central Banks use inflation targeting to manage inflation levels. If the inflation levels spike up, it leads to lower investments and reduced savings in the economy, which has a ripple effect on the living costs, which will increase. To prevent economic collapse, then the government has to institute inflation, targeting to keep checks and balances.
- Ensures flexibility. This type of policy is used to manage inflation levels in the short-term, which gives room for short-term deviations from the target to reduce the output gap variability.
- This monetary strategy involves a lower cost as compared to the other policies. When considering a financial system to put in action, Central Banks consider the expenses incurred in case the method fails to curb inflation. Inflation targeting compared to the other policies has low output costs in the event the inflation targets are not met because they can use interest rates as a corrective measure for achieving the intended goal (Bernanke, 2001).
Disadvantages of Inflation Targeting
- Inflation targeting, according to principles of economics, is not a realistic policy. The economy is driven by various factors that cannot all be checked by a single policy. Applying such a system could restrain economic growth because its implementation would mean the Central Banks have to act consistently through tangible actions to respond to inflationary pressures. When
- Inflation targeting results in high exchange rate volatility. Countries that employ this policy have less flexible exchange rate arrangements because they will need to intervene frequently in the foreign exchange markets. This control of exchange rates would lead to shocks in the goods market that cannot be absorbed as is the characteristic of free-floating exchange rates.
- Inflation targeting has to be preceded with stringent preconditions. Countries that have weak Central bank structures to monitor the market operations cannot effectively implement this policy because it requires fiscal dominance and a strict institutional setup (IMF 2005, p. 165-168).
- Inflation targeting is a short-term policy, and as such, its implementation is not favorable in the economy in the long run. The possibility of fiscal deficits is very likely since governments will be forced to overcompensate through stimulus packages and other injections to the economy to cushion high inflation rates. Inflation targeting will also affect the competitiveness of companies and firms in the given economy because they will be used to operating in a protected zone where inflation is predictable. Such companies, when matched with others in a free market they will perform dismally.
Inflation targeting as a policy in the short-run is a good idea. It can help protect the economy from sudden movements that will lead to panic and destabilize market operations. This monetary policy has been considered a flexible framework to be employed in the shifting of market circumstances. However, a country’s Central Bank should assess their economies to find out whether they have the capacity and how best to implement such a policy.