Reviewed by Sep 30, 2020| Updated on
Inflation targeting is a monetary policy in which a central bank sets a specific target for medium-term inflation rate and declares the target for inflation to the public. Mostly, the monetary policy can support the economy's long-term growth by conserving price stability. The central bank uses its primary short-term monetary weapon, the interest rates.
An inflation-targeting central bank can boost or lower interest rates, respectively, based on above-target or under-target inflation. The conventional ideology is that rising interest rates typically cools the economy to reign during inflation; lowering interest rates generally speeds up the economy and thus increases inflation.
Canada, New Zealand, and the UK were the first three countries to introduce full-fledged inflation targeting in the early 1990s. However, Germany had introduced many elements of inflation targeting elements earlier.
At the beginning of 2012, around 27 countries were considered full inflation targeters by the Bank of England's Center for Central Banking Studies. Other lists report 26-28 countries as of 2010. Since then, the USA and Japan have also introduced inflation targets, although the Federal Reserve of the USA, as the European Central Bank does not consider itself facing inflation.
Inflation forecasts are crucial for the conduct of forward-looking monetary policy, and they play a special role in the inflation targeting framework by acting as an intermediate target. Hence, the significance of accurate forecasts can scarcely be exaggerated. In India, the Reserve Bank of India undertook inflation targeting in August 2016. The decision was taken after India had ~10% inflation rate for around five years.
The amendment to Reserve Bank of India Act, 1934, effective in June 2016, made way for a Flexible Inflation Targeting (FIT) framework in India by defining the primary objective of monetary policy as maintaining price stability together with the objective of growth.
To operationalise this command, the Government of India notified a medium-term inflation target of 4%, with a band of +/- 2% between August 2016 and March 2021. The inflation target is fixed in terms of all-India CPI-Combined issued by the Central Statistics Office (CSO).