With Inflation and Central Bank rate rises making the front pages again, we thought it was worthwhile to publish a short primer on Inflation Targeting.
When did Inflation Targeting first become adopted by Central Banks?
Beginning with New Zealand in 1990 many Central Banks have adopted explicit Inflation targeting as a cornerstone of their monetary policy. Under Inflation targeting a Central Bank will make an ideal target inflation rate public, and then use policy tools to steer an inflation benchmark towards that target.
Figure1: List of Central Banks that explicitly target Inflation. Table includes the target for that bank and the year Inflation targeting commenced.
What tools do Central Banks use to create price stability?
Policy tools principally comprise:
short term interest rate changes,
purchase or sale of government bonds (Quantitative Easing - ‘QE’, or Quantitative Tightening - 'QT')
and (to a lesser extent) reserve requirements (minimum cash bank must keep in their vaults as a percentage of deposits)
Figure 2: Key policy tools for Inflation Targeting
There is a brand consensus among Central Banks that price stability is a common goal. Even Banks that do not explicitly pursue Inflation targeting set it as a key criteria. Notably this includes the Federal Reserve and the European Central Bank.
What do Central Banks have to say about Inflation Targeting?
Subtly different approaches from the Fed, ECB & Bank of England
The Fed states:
“The Federal Open Market Committee (FOMC) is firmly committed to fulfilling its statutory mandate from the Congress of promoting maximum employment, stable prices, and moderate long-term interest rates… The Committee reaffirms its judgment that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate”
In essence the Fed targets price stability within the context of maximum employment.
With similar wording from the ECB:
“The ECB’s primary objective is to maintain price stability, that is, to preserve the purchasing power of the euro. We do this by making sure that inflation – the rate at which the overall prices for goods and services change over time – remains low, stable and predictable… The Treaty does not give a precise definition of what is meant by price stability. The ECB’s Governing Council, after concluding its strategy review in July 2021, considers that price stability is best maintained by aiming for 2% inflation over the medium term.”
The Bank of England:
The Bank of England, which does explicitly support inflation targeting is more direct:
“We are responsible for keeping inflation (price rises) low and stable. The Government has set us a target of keeping inflation at 2%”
The summary of these three central bank targets are shown in the table below.
Figure 3: Comparison of Fed, ECB and Bank of England with respect to Inflation Targeting
Differing Inflation benchmarks
The US Consumer Price Index (‘CPI’), compiled by the Bureau of Labor Statistics, is a broadly used benchmark inflation rate for financial instruments such as TIPS. It is also used as the reference index for USD Inflation Swaps. However, CPI is not the Fed target inflation rate.
Instead of CPI the Fed uses Personal Consumption Expenditures (‘PCE’), compiled by the Bureau of Economic Analysis. As CPI & PCE are different benchmarks, with different baskets of goods, different scope and different averaging formulae for calculating changes to the basket (Laspeyres for CPI & Fisher-Ideal for PCE) the numbers will differ. The chart below shows the difference between both benchmarks since 1978.
Figure 4: Comparison of PCE (Red) and CPI (Green) since January 1978
While the two benchmarks are clearly correlated they are also clearly different. Of great significance is the relative stability of the PCE benchmark since the Fed began its implicit Inflation targeting.
As you can see in Figure 4 above, until very recently PCE has remained around the 2% target. Indeed it has done so for the past three decades. This is consistent with the Fed's goal of maintaining an inflation target within the context of maximising US employment.
The recent spike in April of 2022 to levels not seen since the late 1980s is particularly significant. Hence the current focus on Inflation and the policies of different Central Banks being worthy of daily commentary.
Inflation targeting has been common practice since the 1990s
Central Banks use changes to policy rates, open market purchase & sale of Government Bonds and to a lesser extent reserve requirements to achieve their inflation targets
Many Central Banks that do not explicitly pursue and inflation target have a target as an implicit objective, along with stable interest rates and maximum employment
There are often many different inflation benchmarks for a particular currency. They will likely differ in basket composition, weighting and methodology.