Inflation target: a brief guide

The inflation target is when any country’s central bank takes steps to estimate a future inflation rate, in order to try and steer the economy. The bank then publishes this estimated target. What follows is an attempt to manipulate the actual inflation rate towards this target rate. This is achieved through various methods, including the changes that occur in interest rates, as well as other economic and monetary tools.

Ways of manipulating the inflation rates

In any economy, the relationship between inflation and interest rates tends to be inverse; that is, lower interest rates tend towards higher inflation rates, and vice versa. Under the economic policy of inflation targeting, any central bank moving to raise or lower interest rates will find itself doing so under a degree of transparency. When it comes to maintaining a buoyant economy, this is no bad thing. If the actual inflation rate seems to be above the inflation target, then the central bank would be expected to raise the interest rate. The longer-term effect of this action would usually be to bring down inflation. Conversely, where the actual inflation rate appears to be below the inflation target, then the central bank would most likely lower interest rates. The longer term result of this action would be for the economy to be boosted, with inflation rising.

The advantage of having an inflation target which can prompt such openness is that investors can appreciate what the target rate will be. This clear knowledge of how the interest rates are liable to fluctuate can be factored into any financial speculation. Those proponents of setting an inflation target can make clear cut investment choices, the overall effect of which is to promote increased economic stability.

Shortcomings of an inflation target

The biggest drawback of setting an inflation target which a central bank can then work around is that it economic adjustments must be made within a national context. However, the vagaries of rises or falls in inflation rates are not necessarily tied to internal factors within any one country’s economy. Simply adjusting national interest rates will be ineffectual when set against the worldwide economic picture. This has been the case in recent years, when financial instability has often been a global phenomenon.

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