Inflation targeting vs exchange rate targeting

What makes a central bank effective?

Memorize

Three ingredients: independence, credibility and transparency. They matter for any central bank, whether or not it runs a formal inflation target.

Effective central bankthree ingredients, with or without a formal inflation target

• Independence Memorize shields decisions from the election cycle
  • Operational independence Memorize chooses the interest rate to hit a target the government sets
  • Target independence Memorize also sets the inflation measure, level and horizon
• Credibility Use it people believe it will hit the target, so they build it into contracts
• Transparency Use it explains its views and decisions
  • Inflation reports money and credit, financial markets, real economy, prices, then a two-year forecast

Central bank independence matters because politicians face elections and may be tempted to keep interest rates too low beforehand, which feeds inflation. Policy is therefore best left to an institution remote from the electoral cycle. Independence comes in degrees, since governments usually appoint the head of the central bank, so complete separation from politics is probably impossible.

The two degrees that the exam names:

• Operational independence : the central bank chooses the interest rate (the instrument) to reach a target that the government has set. Several inflation-targeting central banks are of this type.
• Target independence : the central bank also decides the inflation measure, the level and the horizon. A bank with this is both target and operationally independent.

Credibility is the public’s belief that the bank will hit its goal. If everyone expects 2% inflation, they build 2% into wage claims and other contracts, and the belief turns self-fulfilling. This is also why central banks watch inflation expectations so closely: if they rose after an oil price jump and spread into wage claims, inflation could follow. A heavily indebted government that set the target itself would lack credibility, because higher inflation erodes the real value of its debt.

Transparency builds credibility. Many central banks publish regular inflation reports covering, usually in this order, money and credit, financial markets, the real economy (such as the labor market) and prices, followed by a growth and inflation forecast about two years ahead.

Go deeper Peg failures and why credibility is a stock of trust

Know the idea

A central bank spends years building the belief that it will hit its goals, and can lose it in weeks. The same is true of a currency peg. When speculators doubt that the bank has enough reserves or the will to defend the rate, they sell the currency in size. The bank either runs out of reserves or must raise rates sharply, and the peg is abandoned. That has happened several times, in both developed and emerging economies, and it often damages banks and firms that borrowed in foreign currency.

How does inflation targeting work?

Memorize

The central bank announces an explicit inflation target with permitted bounds and uses a wide range of indicators to decide on interest rates. Inflation targeting is now the dominant approach in developed and many emerging economies.

Targeting regimes

• Inflation targeting Memorize explicit inflation goal; short-term rate is the operating target
  • Typical design consumer price index (CPI) about 2%, band of 1 to 3%, aimed about two years ahead
  • Main exceptions Know the idea central banks with a broader mandate or a deflation fight
• Exchange rate targeting Memorize fix or band the currency against an anchor; "imports" its inflation
  • Conventional peg or band central bank buys and sells its own currency
  • Dollarization Know the idea adopts another country's currency outright

The typical design. The target is for consumer price index (CPI) inflation of about 2%, with a band of plus or minus 1 percentage point (so 1% to 3%), aimed about two years ahead. Not current inflation, for two reasons: the headline rate describes the last twelve months, which is already history, and a rate change made today takes time to work through the transmission mechanism.

Why not 0%? The central bank will sometimes miss low. A target of 0% means misses would produce falling prices, and deflation is much harder to fight because the policy rate cannot be cut far below zero. Why not 10%? That level is not price stability, and high inflation is also volatile and uncertain. About 2% is far enough from deflation and low enough to keep prices stable.

Interest rate targeting. The operating target of inflation-targeting banks is usually a short-term interest rate, such as an overnight interbank rate. The inflation target is the goal; the rate is the instrument they move to reach it.

Exceptions. Two prominent central banks have not adopted a formal target of the classic type. One has spent years fighting deflation, where a ceiling-style target seemed beside the point. The other has a broad statutory mandate (maximum employment, stable prices and moderate long-term rates) and watches a core inflation measure of about 2% instead.

In developing economies, the hurdles are larger.

Hurdles

• Thin government bond and interbank markets little to trade for open market operations
• Fast-changing economy neutral rate and money-to-activity link hard to judge
• Rapid financial innovation keeps redefining the money supply
• Weak inflation track record low credibility
• Limited real independence government unwilling to let go

How does exchange rate targeting work?

Memorize

Many developing economies target their currency’s exchange rate rather than inflation. Exchange rate targeting sets a fixed level or a band against a major currency, and the central bank supports it by buying and selling its own currency in the foreign exchange market.

The idea is to tie the economy to one with a credible low-inflation policy, so it “imports” that inflation. If domestic inflation tracks the anchor’s, the exchange rate stays near its target without much effort.

When inflation at home departs from the anchor’s, the central bank has to act:

Domestic inflation vs anchor	Pressure on currency	Central bank action	Domestic effect
Higher	weakens	sells FX reserves, buys own currency	money supply falls, short rates rise (tightening)
Lower	strengthens	sells own currency, buys FX	money supply rises, rates fall (loosening)

The lesson: with a peg, domestic interest rates and money growth must serve the peg and can be volatile, whatever the home economy needs. The commitment has to be credible. If speculators doubt the central bank’s ability or will to defend the rate, they trade against it, and a peg can break when reserves run low.

A stronger step than a peg is dollarization : adopting another country’s currency outright, which then replaces the national currency.

Exam tip Peg plus too much domestic inflation: the currency is under pressure, so the bank sells reserves and rates rise. Peg plus too little: the reverse.

Go deeper Currency boards versus conventional pegs

Know the idea

A conventional peg leaves the central bank some room to manage domestic policy. A currency board commits the bank to issue domestic currency only against foreign reserves at the fixed rate, which removes nearly all discretion. Both are covered in the exchange rate regimes lesson in the capital flows module.