Inflation targeting is a monetary policy strategy used by central banks for maintaining prices at a certain level or within a specific range. Using methods such as interest rate changes, this could help guide inflation to a targeted level or range.
This policy is designed to assure price stability.
Initially, it was a radical plan adopted by New Zealand in 1989, although other countries, most notably Germany, had evolved something close to inflation targeting considerably earlier.
The term “inflation targeting” does not have a formal definition and is practised in different ways around the world.
It does have some core elements. There is an explicit inflation target; it is announced to the public; the monetary authorities aim to hit that target at a defined point in the future; there is some leeway for inevitable errors and shocks; and the monetary authority is not told how to hit the target but is accountable to the public for its performance.
Another benefit is transparency. If the monetary authorities have sufficient respect and credibility that people believe the target will be hit, households and companies can plan ahead, negotiating wages on the basis of expecting low and stable inflation. The policy is self-reinforcing: low inflation expectations lead to low inflation, confirming the low expectations and so on.
Countries adopting inflation targets have tended to have lower and more stable inflation after the change than before, and the framework has proved durable.
Prior to the financial crisis, inflation targeting was widely lauded for helping the UK to sustain more than a decade of stable prices and growth. But after explicit targets for consumer prices failed to prevent the credit bubble and recession that followed, some economists now believe that greater weight should be put on asset prices in determining economic policy.