šÆ Inflation Targeting: The Central Bankerās Compass
š§© 1. Core pieces of the inflationātargeting machine
Imagine a thermostat. You set it to 21Ā°C and the heater or AC turns on automatically. Inflation targeting works like that. The government or central bank announces a number ā for example 2% yearly inflation. If inflation tries to go higher, the bank raises its policy rate. Borrowing becomes more expensive, spending slows, and prices cool down. If inflation falls too low, the bank cuts the rate to encourage spending.
āļø 2. How does the central bank actually pull it off?
It uses a powerful tool: the shortāterm interest rate. Banks borrow money from the central bank overnight. If that rate goes up, commercial banks also raise their rates for you ā for car loans, mortgages, or credit cards. People then spend less, demand slows, and prices stop climbing so fast.
| Country | Target (%) | Started | Note |
|---|---|---|---|
| New Zealand | 1ā3 | 1990 | First to adopt |
| Canada | 2 (midpoint) | 1991 | Joint with govt |
| Euro area | <2 | 1999 | Revised to 2% in 2021 |
| South Africa | 3ā6 | 2000 | Flexible range |
š„ 3. Realālife example: the baguette detective
Imagine you track the price of a baguette every month. In January it costs $2.00. The central bankās target is 2% per year. By December the baguette should cost about $2.04. But because of a wheat shortage the price jumps to $2.15 in just three months ā thatās almost 7.5%! The central bank steps in, raises the interest rate, and makes loans costlier. A bakery that planned to expand postpones buying new ovens. Wheat demand falls, and the price of bread stabilises. The target stays within reach.
ā 4. Important questions students ask
Zero sounds nice, but itās dangerous. If inflation is 0% and the economy stumbles, prices could fall (deflation). People then wait for lower prices, spending freezes, and companies fail. A small positive target like 2% gives a safety cushion.
Usually the central bank alone, or together with the government. In the UK, the Chancellor of the Exchequer sets a 2% target for the Bank of England. In the US, the Federal Reserve chose 2% on its own. The number must be believable ā people have to trust it.
They write a letter explaining why. In Canada, if inflation moves outside the 1ā3% band, the governor must publicly explain. This openness is part of the strategy ā itās called accountability.
š 5. Footnote ā abbreviations & terms
- [1] CPI ā Consumer Price Index; a basket of goods and services (bread, bus tickets, books) that measures the average price change over time.
- Policy interest rate ā also called the benchmark rate; the rate at which the central bank lends money to commercial banks.
- Transparency ā central banks publish forecasts and meeting minutes so the public understands their decisions.
- Deflation ā general decline in prices, often harmful because spending gets postponed.