Independence, credibility, and transparency are crucial parts of an effective central bank, whether or not they target inflation. Therefore, a practical inflation-targeting frame must be transparent and a central bank should be independent. As far as the decision-making process is concerned, it should consider a wide range of economic and financial market indices. Additionally, it must be clear and symmetric in nature. And last, but not least, central banks should set the inflation target at a certain level. For instance, a target above zero percent will help avoid the risk of deflation. But at the same time, it should be low enough to ensure a significant degree of price stability

What Are the Characteristics of an Effective Central Bank?

During the 1990s, both Central bankers and politicians agreed that the most effective way to control Inflation and maintain price stability was to aim for a specific inflation rate. To meet this target they kept track of various economic variables. Nowadays, many economies rely on inflation-targeting frameworks as the foundation of their monetary and macroeconomic policies.

Despite differences across different economies, many believe the effectiveness of inflation-targeting regimes entirely depends on three fundamental principles: the independence of the central bank, its credibility, and the transparency of its policies.

What Is Considered the Independence of a Central Bank?

Typically, the government grants some level of freedom to the central bank tasked with controlling inflation, which is considered crucial. However, politicians often prioritize reelection and may attempt to influence interest rates to enhance their chances of remaining in power. For example, they may keep interest rates low to attract voters, leading to higher price levels. Therefore, it is now widely accepted that an independent organization should make monetary policy decisions independent of the political process. This type of freedom is referred to as operational independence.

While we expect central banks to have some degree of freedom, there are different “shades” of it. For instance, in the real world, governments officially select the head of the central bank. The President of the United States elects the Chairman of the US Federal Reserve’s Board of Governors. At the same time, the Euro area finance minister committee chooses the ECB head. It is difficult to completely separate control from political influence, even though it is an ideal goal.

The ECB is an example of a central bank that has targeted independence. On the other hand, there are other central banks (e.g., in New Zealand or the United Kingdom) that the government order to achieve a specific definition and level of inflation. As a result, these central banks are only operationally independent.

What Is Considered the Independence of a Central Bank?

When planning an inflation-targeting system, the central bank’s independence and the trust of people and organizations in it are crucial. To explain the importance of credibility, let’s consider a situation where the government, rather than the central bank, is responsible for targeting inflation, but the government is significantly in debt. Since high inflation can reduce the real value of debt, the government may have a strong desire to set a higher inflation target or avoid meeting the target altogether, which could put in danger price stability and harm confidence in the currency.

If a government heavily in debt tries to control inflation, people may doubt their commitment. Consequently, this lack of trust could lead to high expectations of inflation, regardless of the target. However, if a famous central bank assumes the role of inflation targeting and people trust they will reach their goal, their belief could be self-fulfilling. For instance, if everyone expects the central bank to achieve a 2% inflation target next year, they might start including that expectation in wage claims and other contracts, which could help make the target a reality. Therefore, central banks pay close attention to inflation expectations to avoid unexpected spikes in inflation. If these expectations suddenly increase due to a rapid rise in oil prices, people would embed them into wage claims, which will cause inflation to rise.

When is a Central Bank Considered Transparent?

So, to build trust, one way for a central bank to achieve this is by being transparent in its decision-making process. As such, many independent central banks that target inflation produce reports each quarter, known as Inflation reports. These reports contain the central banks’ views on a range of indices that they consider when making their monthly interest rate decisions.

Typically, these indices include broad money aggregates and credit conditions, financial market conditions, and developments in the real economy. Upon analysis of these metrics, the central banks then provide a forecast of growth and inflation over a medium-term horizon. Usually, this horizon is for two years. By explaining their views on the economy and being transparent in their decision-making, these independent central banks seek to build a reputation and gain trust. It can help them to influence inflation expectations and ultimately make it easier to meet their inflation targets.

How Do Central Banks Set the Inflation Target?

Whether the central bank or the government sets the target, the level of the target and the horizon over which the target is to be hit are crucial factors in all inflation-targeting frameworks. For instance, many central banks in developed countries target an inflation rate of 2 percent based on a consumer price index. However, since the operation of monetary policy is both an art and a science, these banks are usually allowed a range around the central target of +1 percent or –1 percent. For example, with a 2 percent target, they would be tasked to keep inflation between 1 percent and 3 percent. But why target 2 percent and not 0 percent? The answer is that aiming to hit 0 percent could result in negative inflation, also known as deflation.

IMPORTANT! Deflation is a steady decline in the general price level of goods and services in an economy. It increases the purchasing power of money. It is the opposite of inflation, which raises the general price level on a regular basis. Deflation can have an effect that hampers economic activity. It reduces demand as people and companies delay their purchases to expect lower prices in the future. Additionally, deflation may worsen the debt burden as the actual value of debt increases.

Monetary policy has a limit when it comes to dealing with periods of deflation or high levels of inflation. Targeting an inflation rate higher than 3 percent, for instance, is not a good idea due to the related volatility and uncertainty. The reason for that is that higher targets can lead to destabilizing inflation shocks. Central bankers agree that a target of 2 percent strikes a balance. It is enough to rule out the risk of deflation and, at the same time, to avoid destabilizing inflation shocks.

Furthermore, it’s important to note that the headline inflation rate, which serves as the central bank’s target, shows the increase in a basket of goods and services over the previous twelve months, making it in fact historical data. Additionally, changes in interest rates take time to impact the real economy through the monetary transmission method fully. Hence, central banks focus on inflation estimates two years ahead, rather than on current inflation. Fun fact, there are a couple of central banks that don’t specifically target inflation:

The Bank of Japan has a “yield curve control” policy rather than inflation targeting. It means that the bank sets target levels for long-term interest rates and buys government bonds to keep those rates within the target range. The bank also uses monetary policy tools, such as negative interest rates and asset purchases, to achieve its broader economic goals. Similarly, the European Central Bank (ECB) has no formal inflation target but aims to maintain price stability over the medium term. The ECB defines price stability as an inflation rate of below, but close to, 2 percent over the medium period. The bank uses various tools to achieve this goal, such as interest rates and asset purchases.

Although inflation-targeting demands may vary from country to country, they all share common elements. Specifically, they involve setting a clear inflation target, decent bounds, and a demand on central banks to be transparent in their goals and policy actions. Very often law lays out such targets and demands, laying legal obligations on central banks.

Why Understanding Inflation Targeting and How It Impacts Different Market Players Is Crucial?

Firstly, inflation targeting serves as a method for central banks to manage the economy by keeping price stability. Consequently, traders need to grasp the impact of the inflation target on interest rates, currency values, and investment decisions.

Secondly, central banks often adjust interest rates in response to their inflation targets. They have significant effects on borrowing costs, investment returns, and currency valuations. As a result, traders closely monitor these interest rate decisions to foresee market movements and adjust their trading strategies accordingly.

Moreover, inflation targeting includes the monitoring of key economic indices such as CPIs. They offer valuable insights into the overall health of the economy, which allows traders to make informed trading decisions.

Furthermore, a solid understanding of inflation targeting is vital for asset managers seeking to protect their portfolios from the adverse effects of inflation. By staying knowledgeable about the actions and policies of the central bank, they can develop effective strategies to hedge against inflation and protect their portfolios.

Lastly, market expectations related to inflation play a significant role in shaping investor behavior. Traders must stay informed about inflation-targeting announcements and central bank communications to give a true estimate of market sentiment. This knowledge enables them to predict market reactions and make smarter trading choices.

In summary, understanding inflation targeting equips traders and market players with the necessary knowledge. It allows them to assess the economic landscape, foresee policy changes, and make informed trading decisions. It serves as a valuable tool for risk analysis, adapting strategies, and potentially improving trading results.