How Inflation Targeting WorksFirst, a healthy economy actually does better with some expectation of inflation. Why? When shoppers expect prices to rise in the future, they are motivated to buy more now so they can get the lower price. This "buy more now" philosophy stimulates the demand needed to drive economic growth.
Second, a little inflation is preferable to deflation, which is when prices fall. You'd think that would be a good thing. However, the dangers of deflation are illustrated by the housing market collapse in 2006. As prices fell, homeowners lost equity and even the home itself. New potential buyers rented instead. They were afraid they would lose money on a home purchase. Everyone, including investors, waited for the housing market to recuperate. As this happened, the lack of demand just forced housing prices further into a downward spiral.
Confidence in the housing market wouldn't be restored until buyers could again expect that prices will go higher. This is equally true for any other market where deflation has taken hold. The difficulty is in creating the right economic climate to create rising prices.
That's where inflation targeting comes in. The Federal government, through expansionary monetary policy or discretionary fiscal policy, spurs economic growth by lowering interest rates or taxes, or other ways of adding liquidity, credit and jobs to the economy.
Inflation targeting in the U.S. was introduced by Federal Reserve Chairman Ben Bernanke, who set an inflation target of 2%. This rate applies to the core inflation rate. In January 2012, the Fed reported that it preferred to use the Personal Consumption Expenditure price index, rather than the Consumer Price Index. Either way, the core inflation rate takes out the effect of food and energy prices. The Fed uses the core inflation because food and energy prices are so volatile month-to-month, while the Fed's tools are so slow-acting. It can take six to eighteen months before the effect of an interest rate change can trickle down into the economy.
Why Inflation Targeting WorksInflation targeting works because it sets expectations about inflation and the Federal Reserve's policies. It is the antidote to the stop-go monetary policy of the past. For example, in 1973 inflation went from 3.9% to 9.6%. The Fed raised interest rates from 5.75 to 13 points by July 1974. It then responded to political pressure and dropped the rate to 7.5 in January 1975. Inflation kept barreling ahead, reaching double-digits by April 1975. By changing the Fed funds rate so dramatically over such a short time period, and not staying consistent, the Fed confused price-setters about its policy. Businesses were afraid to lower prices when the interest rate went down because they weren't sure the Fed wouldn't just turn around and raise rates again.
This experience taught Bernanke that managing inflation expectations was a critical factor in managing inflation itself. It lets people know the Fed will continue expansionary monetary policy until inflation reaches that 2% target. As prices rise, people buy more now because they want to avoid higher prices for consumer products. For investments, they buy now because they are confident it will give them a higher return when they sell later. If inflation targeting is done right, prices rise just enough to encourage people to buy sooner rather than later. Inflation targeting works because it stimulates demand just enough.