- Inflation targeting is a monetary policy technique in which a central bank sets an inflation target and adjusts monetary policy to meet that aim.
- Inflation targeting is primarily concerned with maintaining price stability, but proponents feel it also aids economic growth and stability.
- Other conceivable central banking policy goals, such as exchange rate, unemployment, or national income targeting, might be contrasted with inflation targeting.
Who determines the UK’s inflation target?
The Monetary Policy Committee (MPC) of the Bank of England determines interest rates with the goal of bringing two-year ahead Consumer Price Index (CPI) inflation back to the objective of 2%. However, the Bank of England is not a “strict inflation targeter.” This is because lowering interest rates alone to keep inflation under control has the potential to stifle economic growth.
When (New) Labour (headed by Tony Blair) handed the Bank operational independence over monetary policy in 1997, it followed a tougher inflation targeting policy. Indeed, Professor Chris Martin and I discovered in previous research that the Bank’s MPC members used “asymmetric” monetary policy targeting. They pursued a policy of “zone” targeting rather than seeking to reach the 2.5 percent inflation target (based on the targeted, at the time, Retail Price Index minus mortgage interest rate payments gauge of inflation). That is, they were eager to raise the Bank’s interest rate when inflation rose beyond 2.6 percent and to lower it when inflation fell below 1.4 percent.
In other words, the Bank was eager to establish its anti-inflationary authority during its early years of operational independence by “getting harsh” on inflation when it exceeded 2.6 percent. On the other hand, throughout these early years, the Bank did not consider (very) low inflation to be a pressing issue.
In light of growing inflation, what is the current state of UK interest rates? In November 2021, the Bank predicted that CPI inflation would reach 5% in the second quarter of 2022. Whether it raised its policy rate to 1.1 percent by the end of 2023, in accordance with financial market forecasts, or elected to take no interest rate action until 2024, the Bank projected inflation to remain substantially above the 2 percent objective!
Worse, one month later (in December 2021), Ben Broadbent, the Bank’s Deputy Governor and a member of the MPC, predicted that UK inflation would rise “comfortably” above 5% in spring 2022. Even if rising prices are (mostly) due to supply-side bottlenecks, inflation far above 5% puts the Bank of England under further pressure to act quickly. Needless to say, it raises troubling issues about the Bank’s ability to foresee.
All of this begs the question of why the Bank of England is not taking (strong) measures to combat increasing inflation. Is the Bank of England, in other words, giving up on inflation? Of course, the answer is related to the pandemic’s impact and the development (in late November 2021) of the “Omicron” strain.
Figure 1 shows the impact of the pandemic on the UK economy, which graphs UK GDP (percent change from pre-pandemic value) against the so-called “Infectious Disease Equity Market Volatility Tracker” ( percent change from its pre-pandemic value). The latter index covers stories in a large number of US publications that discuss economic/financial instability as well as infectious diseases. The Infectious Disease Tracker was slightly higher in December 2021, owing to concerns about the new “Omicron” variety and its capacity to escape immunizations to some extent. Data on the UK’s Gross Domestic Product (GDP) is released with a lag. GDP grew by barely 0.1 percent month over month in October 2021, according to the most recent figures. As a result, UK GDP remained 0.6 percent below pre-pandemic levels in October 2021.
The two variables have a high and negative association (equivalent to -0.70) as seen in Figure 1. Because the prolonged epidemic is having a negative impact on UK growth, MPC members are less reluctant to act on inflation because a succession of interest rate hikes could “derail” economic recovery. a contagious disease Because the volatility tracker is transnational in scope, it has an impact all over the world.
Figure 1 shows that US GDP was 3.5 percent higher in October 2021 than it was before the outbreak. Also note the inverse relationship between the tracker and US GDP (correlation equals -0.73), implying that further increases in the tracker as a result of the ‘Omicron’ variant will impede economic recovery in the US and, as a result, the rest of the world (including the UK), because global growth is influenced by US growth.
Figure 1: GDP in the United Kingdom, GDP in the United States, and Infectious Disease Volatility monitor ( percent change from pre-pandemic period for all three series). Data collected on a monthly basis.
Sources: ONS, IHS Markit, ONS, ONS, ONS, ONS, ONS, ONS, ONS, ONS, ONS, ONS, ONS, ONS, ONS Economic Policy Volatility Tracker Uncertainty
It’s also worth noting that the Bank’s work has been made more difficult by the recent drop in the sterling exchange rate, which adds to inflationary pressures. The successful launch of the UK immunization program offered a welcome shot in the arm for sterling in 2021, limiting, to some extent, UK inflation. As seen in Figure 2, which compares the rollout of the UK vaccination program to the one in the United States, this is no longer the case. The vaccine rollout in the UK is still proceeding well, as seen in Figure 2, but “sterling’s immunization boost has faded,” according to David Smith (Economics Editor of The Sunday Times).
Boris Johnson has recently announced the government’s plan to speed up the booster rollout in order to combat ‘Omicron.’ This is anticipated to have the beneficial economic consequence of strengthening sterling and lowering the rate of inflation to some extent.
Figure 2: Sterling and the immunization program’s rollout. Data from January to December 2021, on a daily basis
Sources of data: Sterling: FRED Economic Data; immunization program rollout: Our World in Data
All of this, together with the development of the “Omicron” variation and new COVID-19 restrictions announced by Boris Johnson on December 8, 2021, makes it exceedingly probable that the Bank of England MPC members will postpone a rate hike despite rising inflation. To put it another way, the Bank of England is still concerned about inflation. Despite the fact that “Omicron” fears have taken hold, the UK economy has adapted effectively to previous Covid-19 restrictions, implying only a minor delay in interest rate hikes…
Is the MPC in charge of setting the inflation target?
The rate of inflation, which is determined by monetary policy, is a measure of how much prices are growing. We set monetary policy in order to meet the government’s goal of keeping inflation at 2%.
Inflation that is low and stable is healthy for the UK economy, and it is our primary monetary policy goal.
We also support the government’s main economic goals of employment and growth. In the immediate term, we may need to strike a balance between our low-inflation aim and encouraging economic development and job creation.
Every year, the Chancellor establishes a framework for us to follow when it comes to monetary policy. In a remit letter, they submit this to our Governor.
What is the purpose of central banks targeting inflation?
The International Monetary Fund (IMF), on the other hand, has made a concentrated effort to encourage central banks in developing nations to adopt inflation targeting. When a central bank pegs its currency rate to the US dollar or euro, it is effectively importing the monetary policy of another country, which can be problematic when economic structures differ. Inflation targeting, on the other hand, allows the central bank to concentrate on its own economy.
Controlling inflation through interest rate setting necessitates a reasonably well-developed financial sector in order for interest rates to have a substantial impact. However, a significant portion of the task is accomplished by channeling people’s expectations. If everyone acts as if inflation will average 2%, then that is exactly what will happen! As a result, excellent communication and trust in the appropriate authorities – usually an independent central bank – are critical.
Inflation targeting has had a lot of success in terms of price stability and expectations anchoring. The financial crisis of 2007-08, however, exposed its flaws.
My first week as Executive Director for Markets at the Bank of England, and as a member of the Monetary Policy Committee, coincided with the Bank of England cutting interest rates to 0.5 percent and introducing quantitative easing (QE).
Inflation and output were already dropping at the time, and deflation was a genuine possibility. What do you do when nominal interest rates are constrained by the zero lower bound? Our strategy was to print money efficiently.
Why are banks so keen on inflation?
- Inflation is defined as an increase in the price of goods and services that results in a decrease in the buying power of money.
- Depending on the conditions, inflation might benefit both borrowers and lenders.
- Prices can be directly affected by the money supply; prices may rise as the money supply rises, assuming no change in economic activity.
- Borrowers gain from inflation because they may repay lenders with money that is worth less than it was when they borrowed it.
- When prices rise as a result of inflation, demand for borrowing rises, resulting in higher interest rates, which benefit lenders.
How can banks keep inflation under control?
The Central Bank and/or the government are in charge of inflation. The most common policy is monetary policy (changing interest rates). However, there are a number of measures that can be used to control inflation in theory, including:
- Higher interest rates in the economy restrict demand, resulting in slower economic development and lower inflation.
- Limiting the money supply – Monetarists say that because the money supply and inflation are so closely linked, controlling the money supply can help control inflation.
- Supply-side strategies are those that aim to boost the economy’s competitiveness and efficiency while also lowering long-term expenses.
- A higher income tax rate could diminish expenditure, demand, and inflationary pressures.
- Wage limits – attempting to keep wages under control could theoretically assist to lessen inflationary pressures. However, it has only been used a few times since the 1970s.
Monetary Policy
During a period of high economic expansion, the economy’s demand may outpace its capacity to meet it. Firms respond to shortages by raising prices, resulting in inflationary pressures. This is referred to as demand-pull inflation. As a result, cutting aggregate demand (AD) growth should lessen inflationary pressures.
The Bank of England may raise interest rates. Borrowing becomes more expensive as interest rates rise, while saving becomes more appealing. Consumer spending and investment should expand at a slower pace as a result of this. More information about increasing interest rates can be found here.
A higher interest rate should result in a higher exchange rate, which reduces inflationary pressure by:
In the late 1980s and early 1990s, interest rates were raised in an attempt to keep inflation under control.
Inflation target
Many countries have an inflation target as part of their monetary policy (for example, the UK’s inflation target of 2%, +/-1). The premise is that if people believe the inflation objective is credible, inflation expectations will be reduced. It is simpler to manage inflation when inflation expectations are low.
Countries have also delegated monetary policymaking authority to the central bank. An independent Central Bank, the reasoning goes, will be free of political influences to set low interest rates ahead of an election.
Fiscal Policy
The government has the ability to raise taxes (such as income tax and VAT) while also reducing spending. This serves to lessen demand in the economy while also improving the government’s budget condition.
Both of these measures cut inflation by lowering aggregate demand growth. Reduced AD growth can lessen inflationary pressures without producing a recession if economic growth is rapid.
If a country had high inflation and zero growth, then cutting aggregate demand would be more distasteful as reducing inflation would lead to lower output and increased unemployment. They could still lower inflation, but at a considerably higher cost to the economy.
Wage Control
Limiting pay growth can help to lower inflation if wage inflation is the source (e.g., powerful unions bargaining for higher real wages). Lower wage growth serves to mitigate demand-pull inflation by reducing cost-push inflation.
However, as the United Kingdom realized in the 1970s, controlling inflation through income measures can be difficult, especially if labor unions are prominent.
Monetarism
Monetarism aims to keep inflation under control by limiting the money supply. Monetarists think that the money supply and inflation are inextricably linked. You should be able to bring inflation under control if you can manage the expansion of the money supply. Monetarists would emphasize policies like:
In fact, however, the link between money supply and inflation is weaker.
Supply Side Policies
Inflation is frequently caused by growing costs and ongoing uncompetitiveness. Supply-side initiatives may improve the economy’s competitiveness while also reducing inflationary pressures. More flexible labor markets, for example, may aid in the reduction of inflationary pressures.
Supply-side reforms, on the other hand, can take a long time to implement and cannot address inflation induced by increased demand.
Ways to Reduce Hyperinflation change currency
Conventional policies may be ineffective during a situation of hyperinflation. Future inflation expectations may be difficult to adjust. When people lose faith in a currency, it may be essential to adopt a new one or utilize a different one, such as the dollar (e.g. Zimbabwe hyperinflation).
Ways to reduce Cost-Push Inflation
Inflationary cost-push inflation (for example, rising oil costs) can cause inflation and slow GDP. This is the worst of both worlds, and it’s more difficult to manage without stunting growth.
What is the European Central Bank’s inflation target?
The ECB’s Governing Council revealed its new monetary policy approach in July 2021. Having previously attempted to keep inflation under control, “It now deems price stability to be best maintained by aiming for a 2 percent inflation objective for the medium term, which is below, but close to, 2 percent. The new objective is “Symmetric,” which means that deviations above and below the aim are both unacceptable. However, in order to avoid negative deviations from becoming permanent, the ECB’s efforts may result in temporary periods of inflation moderately above 2%.
The ECB attempts to communicate with the general public in a clear and understandable manner. We used the August 2021 Bundesbank Online Panel Households (BOP-HH) to ask around 3,000 households about their inflation expectations for the next two to three years, just after the monetary policy changes were implemented, to see if they take the ECB’s strategy into account when forming beliefs about future price developments. Using a randomized control trial, we give households with information on the new and prior ECB strategies. The experiment is divided into three parts. To begin, all participants are informed that the plan up until July had been to keep annual inflation at a low level “over the medium term “below, but close to, 2%,” and that, under the revised strategy in force since July, the aim is inflation of 2% over the medium term. The fact that this new aim is symmetric, which means that both negative and positive deviations from it are considered equally undesirable, is also stated clearly.
Second, all participants are requested to believe that the ECB is still aiming for a rate of inflation of 2% “Over the medium term, the unemployment rate will be below, but close to, 2%.” The respondents are then asked to predict inflation rates for the next two to three years, which is the same time frame as the ECB’s projection horizon. Third, the participants are divided into groups at random and given different monetary policy and inflation assumptions to consider. In the August 2021 survey, a total of five subsamples were produced. The first group was told to assume that, in keeping with its new policy, the ECB aims for an annual inflation rate of 2% over the medium term. Respondents were reminded, as they had been before, that the inflation target is symmetric, meaning that both negative and positive deviations from the target are equally undesirable. The second group received the same wording as the first, but they also received an explicit version of the ECB’s official press release on the revised inflation target, which highlights the prospect of above-target inflation.
Figure 1 compares the old monetary policy strategy to the new monetary policy strategy in terms of medium-term inflation expectations. The bar graph depicts the average individual probabilities for the various outcomes “dark blue bars depict expectations when the “symmetrically 2 percent ” policy is supplemented with information about the possibility of a temporarily above-target inflation rate; dark red bars depict expectations when the “symmetrically 2 percent ” policy is supplemented with information about the possibility of a temporarily above-target inflation rate; and light red bars depict expectations when the “symmetrically 2 percent ” policy is supplemented with information about the possibility of a temporarily above-target inflation rate. We can notice a moderate movement in the probability mass towards the right by comparing the first two bars in each example dark blue with dark red. As a result of this shift, inflation expectations are slightly higher under the new strategy than they were under the old one. The distinctions between the dark blue and light red bars, on the other hand, are more noticeable.
Based on these findings, we can deduce that respondents initially did not distinguish between an inflation target of “below, but near to, 2 percent” and “symmetrically 2 percent.” The added explanation that the inflation rate may exceed the 2% objective under certain conditions caused a statistically significant movement to the right in inflation expectations. In particular, more respondents responded that they expect inflation to be greater than 2% but not higher than 3% in the medium future. Meanwhile, under the ECB’s new strategy, inflation rates of less than 1% and more than 3% were seen as significantly less likely than under the previous strategy and also than under the aspirational strategy “without mentioning a temporary overshoot, the “symmetrically 2 percent” inflation target is reintroduced.
In the United States, who is in charge of inflation policies?
The Federal Reserve’s Inflation Control Tools The Federal Reserve has a number of instruments at its disposal to keep inflation under control. Open market operations (OMO), the fed funds rate, and the discount rate are generally used in tandem.
Where did the aim of 2% inflation come from?
Inflation targets became more important when New Zealand’s strategy took off “It’s all the rage,” stated economist Mervyn King in a 1997 speech. Canada was the third country to implement inflation targeting, and it set a target of 2% as well. Several other countries followed suit later on. Brash uses this as an example of how ideas propagate inside the little priesthood of central bankers, with a laugh: “We’d get together in Basel and other places and chat about it.”
Why is the inflation objective 2?
The government has established a target of 2% inflation to keep inflation low and stable. This makes it easier for everyone to plan for the future.
When inflation is too high or fluctuates a lot, it’s difficult for businesses to set the correct prices and for customers to budget.
However, if inflation is too low, or even negative, some consumers may be hesitant to spend because they believe prices will decline. Although decreased prices appear to be a good thing, if everyone cut back on their purchasing, businesses may fail and individuals may lose their employment.
How do you set inflation goals?
Interest rates can be used as an intermediate target by central banks when attempting to control inflation. If the central bank believes inflation is below or above a target level, it will cut or raise interest rates. Raising interest rates is thought to stifle inflation and, as a result, economic growth. Interest rates are being lowered in the hopes of boosting inflation and accelerating economic growth.