How are inflation targets set?

In the last 20 years, inflation targeting has become the monetary policy of choice in about 30 industrialised and emerging economies. Inflation targeting is characterised by an explicit numerical target for inflation and the fluctuation band for inflation. Many commentators have focused on various aspects of inflation targeting; most notably, whether inflation targeting represents a successful monetary policy regime and whether inflation targeting should be modified after the recent financial crisis in a way to reflect greater financial stability considerations.
Still, very little attention has been given to the process of inflation target setting. Although the vast majority of policymakers believe that the inflation target for year-on-year inflation should be about 2%, inflation targets differ from country to country (see Chart) and are often revised.

An important question is which authority is responsible for setting the target; is it the central bank itself, the government, or both? In addition, there is very little systematic evidence on which factors matter for inflation target setting. In recent research, we gather evidence on these two issues from official central bank and government publications, and from a questionnaire that we sent to about 20 inflation-targeting central banks.

We find that the most common practice is that inflation targets are set jointly by the government and the central bank. However, the practice when only one authority is responsible for setting the target is not rare. Government is solely responsible for setting the target in the UK and Israel, while the responsibility to set the target in the Czech Republic or Sweden belong to their central banks (see Table).

Although it is typically claimed that inflation targeting is characterised by a high degree of transparency, the amount of information about the process of inflation target setting and about the factors that authorities deem important differs largely from country to country. Some authorities only enumerate the benefits of low inflation, while other authorities discuss the inflation target determinants in great detail. Overall, the evidence suggests that the authorities seem to consider many factors when they decide about the inflation target. Inflation and economic growth are among the most frequently stated factors. Measurement error of CPI inflation, deflation risk, foreign inflation and the zero interest rate lower bound are the often mentioned reasons for targeting low but positive inflation, as the Table documents.

Although surveying official publications and analysing the responses from the questionnaire is supposedly good to start with, there may be more factors that play a role in inflation target setting. These factors may be predominantly of institutional or political nature such as central bank credibility or central bank independence. And, in the case of less independent central banks, it might be that government party orientation influences inflation target setting.

An important issue for econometric analysis is to account for the fact that (1) inflation targets are typically set as a range rather than as a point, and that (2) not only do macroeconomic and other factors influence the inflation target, but also vice versa.

Accounting for these two issues, our results suggest that both a higher level and higher variability of inflation are associated with higher targets. The importance of inflation volatility highlights the concerns about the risk of deflation and the preference for higher inflation targets. Our results also show that policymakers consider economic growth important for setting the target. This somewhat contradicts the claims that the adoption of inflation targeting may be associated with increased output volatility and suggests that it is more reasonable to assume that actual inflation targeting is, in fact, flexible rather that strict. Finally, foreign inflation is positively associated with higher inflation targets, which supports the hypothesis that domestic inflation is largely driven by global forces. Our results also suggest that policymakers establish a wider target range for the inflation rate when the macroeconomic environment is less stable.

As regards the institutional factors, more credible central banks are found to set lower inflation targets. This is probably because they are more confident about maintaining the low inflation environment. We do not find that central bank independence and government party orientation help to explain the variation in inflation targets, possibly because inflation targeting central banks are already granted a sufficient degree of independence from government’s potential pressures.

To summarise, our research suggests that both the level and the range of inflation target correspond to domestic and foreign macroeconomic fundamentals and also that central bank credibility is vital for delivering low inflation.

Roman Horváth is the head of research unit and advisor to the Board, Czech National Bank, and lecturer at the Charles University, Prague. Jakub Mateju is with the Center for Economic Research and Graduate Education and Economics Institute (CERGE-EI) and Czech National Bank.



Source:-
http://www.financialexpress.com/news/how-are-inflation-targets-set/808321/0


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Ankit Wani
Intern @ DENIP Consultants Pvt. Ltd.