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What is inflation targeting
Here's how Wikipedia defines inflation targeting: Inflation targeting is a monetary policy in which a central bank has an explicit target inflation rate for the medium term and announces this inflation target to the public. The assumption is that the best that monetary policy can do to support long-term growth of the economy is to maintain price stability. The central bank uses interest rates, its main short-term monetary instrument.
Anchoring the Monetary Policy
A monetary policy framework has to establish a nominal anchor for the economy. A nominal anchor is a factor that policymakers utilize for keeping the price level steady. The anchor can take various forms such as Gross Domestic Product, GDP, money supply, or the consumer price index. However since the demand for money fluctuates due to developments in the financial markets, growth of money supply as an anchor is not fully satisfactory.
Another way to anchor a currency is the currency peg. Here the value of the currency is kept at a certain ratio, with reference to another foreign currency. For example the rupee can be pegged at Rs. 50 to the USD. Whatever the economic conditions in the rupee area, the currency value would be maintained at that rate. Of course the value of the USD also fluctuates. Hence, the rupee will also weaken or strengthen in tandem with the USD.
This system gives the foreign currency an undue influence on the local economy. It also hampers the central bank from responding positively to shocks emanating from changes in the terms of trade, that is, exports vs. imports. The central bank would also find it difficult to react to changes in the real interest rate. Hence, today, countries prefer to float their currencies. In this scenario, central banks need a new anchor and have found that inflation targeting gives the best results, especially when operating with flexible exchange rates.
Another factor in favour of inflation targeting is that it gives central banks much greater focus. For example, ten years ago, in the 2004-2007 period, India witnessed a big jump in foreign investment, provoking the Reserve Bank of India to reduce interest rates, to prevent the value of the rupee from rising. This was at a time when the economy was growing at the fastest pace since Independence. An effectively pro cyclical monetary policy led to inflationary conditions. Inflation rose to 5% initially and then hit double digits and is yet to be tamed fully. Inflation targeting is likely to prevent such policy failures.
Targeting Inflation
For inflation targeting to be successful, there should be a central bank 'able to conduct monetary policy with some degree of independence', says the IMF. The second requirement is the willingness and ability of the monetary authorities not to target other indicators, such as wages, the level of employment, or the exchange rate. (IMF)
When these two conditions are satisfied, the policy can be operated. However, in practical terms, these other steps are also often taken, according to the IMF.
Establish explicit quantitative targets for inflation for a specific number of periods ahead. Indicate clearly and unambiguously to the public that hitting the inflation target takes precedence over all other objectives of monetary policy. Set up a model or methodology for inflation forecasting that uses a number of indicators containing information about future inflation. Devise a forward-looking operating procedure through which monetary policy instruments are adjusted (in line with the assessment of future inflation) to hit the chosen target.
How it works
The policy works in this way. The central bank prepares a forecast of the expected inflation in the future. It compares this with the target rate, which generally is fixed in consultation with the government. Based on the difference between the two rates, the central bank makes monetary policy changes. The idea is to bring the actual rate as close as possible to the forecast rate and keep it there. The target rate can be an upper limit beyond which inflation may not go. Many nations have adopted a central point, with flexibility to err, up to a degree, on both sides. This gives central banks more elbow room to manoeuvre in adopting strategies for maintaining monetary stability, while being able to respond to unforeseen crises. The target rate is usually set in the low single digits. For example, the European Central Bank and the US Federal Reserve have a 2% target as has the Bank of England. Recently the Indian government announced that it would aim for a rate of 4% out to 2021.
How to target
Central banks need not adhere to the target rate at all times. In general, the aim is to achieve it over the medium term, say two or three years. In the short term, this gives central banks the flexibility to respond to unexpected events like downturns and overheating of economies. Says the IMF, 'A major advantage of inflation targeting is that it combines elements of both "rules" and "discretion" in monetary policy. This "constrained discretion" framework combines two distinct elements: a precise numerical target for inflation in the medium term and a response to economic shocks in the short term. Because of the medium-term focus of inflation targeting, policymakers need not feel compelled to do "whatever it takes" to meet targets on a period-by-period basis.
Is inflation targeting good for an emerging economy?
Under Dr. Rajan's leadership, RBI formally adopted explicit inflation targeting as an overarching monetary policy objective in February 2015. Prior to this, RBI's stated policy was always to steer monetary policy based on twin objectives of growth and moderate inflation. What inflation targeting does in practice is to place clear responsibilities for growth and inflation respectively. The Government, equipped with its fiscal policies and developmental policies will aim for growth of the economy, while RBI being the monetary authority, will focus on maintaining price stability - which ultimately is critical for sustainable growth. What this does is remove any doubt on who is responsible for what. Accountability increases. Results normally follow with accountability.
So, when inflation was still uncomfortably high, if RBI had yielded to pressure to drop rates to spur growth, we would have set in motion a short term, unsustainable growth spurt induced by the wrong reason - namely cheap credit. The world has seen that cheap credit in itself is not really a sustainable growth booster. What would have happened however is even higher inflation, which would then take years to tame - like we saw after 2007.
The practice of inflation targeting
New Zealand was the first country to adopt inflation targeting way back in 1989. Over the decades many more countries have joined the bandwagon. The US started to follow this procedure in 2012, while Japan began to do so in 2013. India formally adopted the principle in February 2015.
However, inflation targeting is not a dogma to be followed rigidly. In an era of global economic dynamics, large flows of trade and investments and freely traded currencies, each country must find the appropriate means and use the correct tools to implement this policy.
Central banks and government authorities must always bear in mind that the policy should be geared towards achieving low, stable inflation and maintaining it there over a long period of time.
 
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