What should the inflation target be?

Central banks around the world have taken to adopting an official target for inflation since the 1990's. This was the result of the failure of all previous attempts to manage inflation and included exchange rate targets, fixed exchange rates and controlling the supply of money.

To the surprise of most the targeting of inflation has worked (although arguably this allowed conditions for the GFC to occur). The target adopted is met by influencing the demand for money by manipulating interest rates - the price of money. It is accepted however that there are 'long and variable' lags in such monetary policy and so most central banks try to manage the inflation rate over the next two years rather than influence the next set of inflation figures.

The policy of adopting a target that is not 0% inflation (very popular among politicians as an aim in the 1970's and 80's) is that there are benefits and costs of low and stable inflation, Most central banks have adopted a target of around 2% on the CPI measure. For example the Bank of England have a 2% target with a 1% margin either side before they must explain their failure. The Australian central bank, the RBA, has a target of 2 to 3% over the economic cycle.

The Australian target is much more flexible than the Bank of England target, but seems the same type of price stability. Enough inflation to allow changes in the economy and growth, but not so much that it threatens the efficiency of the price mechanism. All central banks know that it is price volatility that causes the greatest harm.

Presently inflation is below target in most OECD countries. This has led to some people saying that the targets are now too low and should be adjusted downwards. This is to ignore the dangers that too low an inflation rate can bring. In Australia's case the country is too at risk of price fluctuations due to volatile commodity markets and a lower target could easily lead to deflation.

In the article below the views of the Governor of the RBA are discussed on why the inflation target should not be changed.

The Financial Review article is here

This article focuses on Australian monetary policy and so is of interest to VCE students, in particular because it talks about current policy and the influences on decision making. IB students are also required to have detailed knowledge on monetary policy and examples of its workings.