'Inflation targeting'

The European Central Bank meets on Thursday for another interest rate decision. The ECB's 'inflation target' has come under scrutiny: even though the ECB misses its below-2% target every year, it has not changed this target for the past eight years.

Inflation targeting works by setting objectives and constraints on certain economic variables, and in so doing seeks to control expectations. Providing that the central bank executing the policy is credible and the targets chosen are realistic, this reduces the cost of inflation management. It has been successful in countries that find it difficult to reduce inflation, but where the central bank is trusted and sets a target regarded as suitable by the markets.

This is because inflation expectations can be lowered effectively ahead of time, rather than economic actors first having to observe that inflation is lower and then change their behaviour. This reduces the time required for disinflation and the amount of real economy growth that is sacrificed in the meantime. Many Central European transition countries benefited in this way when they introduced inflation targeting at the end of the 1990s and in the early 2000s.

A quasi-inflation targeting system was first introduced in Sweden in the mid 1930s, although it was abandoned after a few years. The idea was revived in New Zealand in the second half of the 1980s, and implemented in 1990. The next three years saw its introduction in a further five medium-sized advanced economies: Canada, the UK, Finland, Australia, and Sweden. Their experience proved that the system does not cause any harm, and provided preliminary evidence that it was highly beneficial. The second big wave of introductions came in 1998-2002, when the new ECB adopted the system, along with many of the more advanced emerging markets.