Why do most central banks target inflation?

"Is Inflation Dead?" posed the cover story of Bloomberg Businessweek on April 22 this year. 

Many other commentators have been asking the same question – at least since Roger Bootle’s book The Death of Inflation was published as long ago as 1996.

Such a question reveals many things. First of all, that the questioner is not aware of the many countries around the world where inflation remains a big problem. I was recently in Ghana where Consumer Price Index (CPI) inflation was more than nine per cent and it is not the worst: Venezuela has hyperinflation, with recent official data recording inflation as being more than 130,000 per cent per annum in 2018! 

And it ignores history, which shows that inflation periods come and go. Since the UK’s Monetary Policy Committee was created in 1997, UK CPI inflation has averaged almost exactly two per cent - but it has varied from just below zero to more than five per cent.

It also disregards the fact that inflation may be low in the developed world, in part, precisely because of inflation targeting frameworks designed to keep it there. To change that policy framework would be a bit like a farmer fencing in their animals so that none of them escaped - and then declaring the problem solved and that the fence wasn’t needed any more!

Given its evident success, you might think that inflation targeting has become the overwhelming policy framework internationally and that every country in the world was diligently pursuing the same policies.

You would be wrong. In fact many more countries use an exchange rate as their nominal anchor - with varying degrees of success - rather than target prices directly.

According to the IMF, out of nearly 200 countries in the world, only around 40 declare themselves to be inflation targeters. Including those who say they have a ‘price stability’ objective and for whom their framework looks remarkably like an inflation target boosts that number, but it’s still much less than a half of all countries.

In 2018 67 countries had an identifiable inflation target; some just a number, some a range and others a maximum. The chart shows the distribution of the central points (or maximum), with 20 countries having targets or upper limits of two per cent or 2.5 per cent, including most of the large countries in the developed world (and counting the eurozone as just one). More interesting is the spread - a ‘shoulder’ out to nearly six per cent, and a ‘tail’ above that.

Why do countries have such different policy objectives? Usually it comes down to the economic structure of the country. For a country that is mainly a commodity exporter, such as the oil producing states in the Middle East, it may make perfect sense to simply tie the domestic currency to an international standard - usually the US dollar - as that’s where a large part of government and private sector incomes will originate.

Elsewhere, it depends on the state of economic development. To be competitve manufacturing and commodity exports must be in line with the world market determined price, often specified in US dollars. With most of the developed world targeting overall inflation at around two per cent, global manufacturing price inflation tends to average close to zero (with some goods falling in price and others rising). 

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A developing country can be expected to have faster growth, especially in the service sector where there is less scope for productivity growth. So countries at different stages of development can have higher domestic inflation rates, even if their exchange rates remain relatively constant. That’s one reason why the main part of the distribution of inflation targets goes up to about 5.5 per cent.

What about those with higher targets? Well, the biggest problem tends to be government expenditure. Governments like to spend money – yet they struggle to raise enough taxes or observe limits to what they can borrow.

Higher inflation rates nearly always result from an inability of the government to fund itself - printing money and/or inflating away debt appears easier. They also like to maximise growth and high employment in the short run, even when excessive growth leads inevitably to high inflation and eventual recession or worse.

However, the International Monetary Fund (IMF) has made a concerted effort to move central banks in developing countries to inflation targeting. A central bank pegging its exchange rate to the US dollar or euro really means it is importing another country’s monetary policy, which can be problematic when economic structures are different. Instead, inflation targeting enables the central bank to focus on its own economy.

Controlling inflation through the setting of interest rates ultimately requires a reasonably well-developed financial sector so that interest rates have a significant impact. However, a lot of the work is actually done through channelling people’s expectations. If everyone behaves as if inflation will average two per cent then, hey presto, that’s what happens! Hence the importance of good communications and trust in the relevant authority - usually an independent central bank.

Why are so many central banks inflation targeters?

Inflation targeting has been highly successful at achieving price stability and anchoring expectations. However, the financial crisis in 2007-08 exposed its limitations.

My first week in a new job at the Bank of England as Executive Director for Markets, and becoming a member of the Monetary Policy Committee, coincided with interest rates being cut to 0.5 per cent and the Bank announcing it was to embark on quantitative easing (QE).

At that time inflation and output were already falling and there was a real danger of eventual deflation. With the constraint of the zero lower bound on nominal interest rates, what do you do? Our approach was to effectively print money.

QE in its purest form is the creation of extra money, to push up asset prices and push down long-term interest rates by effectively taking long-term bonds out of the economy. We were giving investors cash to spend instead of government bonds, helping to stimulate the demand for private sector assets.

That was how we approached the crisis at the Bank of England, but the US Federal Reserve had different issues and so bought mortgage-backed securities to support a housing market where excessive sub-prime lending had led to a crash. Meanwhile, the European Central Bank bought corporate bonds in an effort to stimulate credit supply.

Although it was a global crisis, central banks across the world found many different variations on QE. As with inflation targets, how they operate depends on the structure of their economy.

Why do central banks have different objectives?

So what we observe is that, even on fundamental issues, central banks around the world behave differently. That is despite the fact that the different tools they use could, in principle, be available to all of them.

We delve deep into the fundamentals underlying central bank policies on the MSc Global Central Banking and Financial Regulation, designed in conjunction with the Bank of England.

We look not just at monetary policy, but financial stability, banking supervision and other topics to take a broad view of central bank responsibilities, objectives, balance sheets and operations. Not just to see what they do differently, but to ask why?

Find out more about banking regulation on the MSc Global Central Banking and Financial Regulation or download a brochure.

Paul Fisher is Chair of the London Bullion Market Association and a former member of the Bank of England's Monetary Policty Committee. He teaches Comparative Central Banking on the MSc Global Central Banking and Financial Regulation.

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