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Inflation Targets

 


Many countries operate inflation targets. The number of countries with explicit inflation targets increased almost sevenfold between 1990 and 1998 from 8 to 54.  Since October 1992, the British Government has pursued an explicit inflation target for the economy. When Labour came to power in May 1997, they set the target for RPIX inflation at 2.5% (+ or - 1%) for the next five years.

 


The Bank of England Monetary Policy Committee sets interest rates with a view to meeting the inflation target over the next two years.  If RPIX inflation moves 1% either side of the 2.5% target, the Governor of the Bank has to write an open letter to the Chancellor explaining the reasons for the inflation undershoot / overshoot and the steps the MPC are taking to bring inflation within the target zone again.  Over the last seven years, RPIX inflation in the UK has stayed within 1% of the target measure. The 1990s has seen a return to the low, stable inflation last seen in the 1960s.

 


 


ADVANTAGES OF AN INFLATION TARGET

An effective inflation target can have several economic benefits:

        It can reduce inflationary expectations if people believe a low inflation target will be met. This will then reflect in the wage demands of people in work. If employees expect low inflation they may be prepared to accept a slower growth of pay. This reduces the risk of cost-push inflation in the economy. A fall in inflation expectations can cause an inward shift of the Phillips Curve.

        A target gives monetary policy a clear anchor and improves the accountability and transparency of economic policy-making. The quarterly Bank of England Inflation Report is a highly detailed assessment of economic trends and the Bank's best guess about future movements in inflation. All A-Level Economists and Degree students should make a habit of reading it!

        Sustained low inflation improves prospects for higher levels of capital investment in both manufacturing an service industries. This is because businesses will not demand such high nominal rates of return on potential investment projects if they believe that inflation will remain low and stable.

        A Bank of England report in August 1999 argued that inflation targets have been successful in reducing inflation expectations and improving people's understanding of the inflation process

 

POTENTIAL DISADVANTAGES OF AN INFLATION TARGET

        The main drawback is that a narrow inflation target is risky for an open economy such as the UK. Am open economy relies heavily on exports and imports and imposes few restrictions on free trade between countries.

        Fluctuations in the exchange rate and changes in inflation rates in other countries or in the prices of imported goods and services can push the domestic inflation rate higher and lead to increases in interest rates. Higher interest rates have the effect of damaging economic growth and employment.

        There is a danger that strict adherence to a tough inflation target may lead to the economy operating well below its long-run productive potential. This can create much higher unemployment - which in itself generates economic and social costs.

 

Nonetheless, most countries have decided that some target for inflation should be maintained. How they achieve the target is a matter of continuous economic debate!

 

 

 

E-mail Steve Margetts