Inflation Targeting

A credible inflation target tells the public how the central bank reacts to misses. It needs a forecast horizon, a measure of inflation, a tolerance for temporary shocks, and a language for explaining why the return path is fast or slow. The Federal Reserve's Statement on Longer-Run Goals and Monetary Policy Strategy, updated in 2020, codifies the U.S. framework explicitly around these elements ^[1].

The target is doing work only when price setters and wage bargainers believe the miss will not persist. If the public hears a number but cannot infer the reaction function, the anchor is weaker than it looks. New Zealand adopted the world's first explicit inflation target in 1990 and the design proved durable precisely because the Reserve Bank of New Zealand's institutional contract required explicit accountability for misses ^[2].

A relative-price shock creates a dilemma. Tightening enough to force headline inflation back immediately can sacrifice output for a shock monetary policy cannot produce more of. Looking through the shock can be right if expectations remain anchored. The Bank of Canada's inflation-control framework explicitly addresses the tradeoff between speed of return and output stability when supply shocks hit ^[3].

The danger is repetition. If one supply shock follows another, firms and workers may stop treating misses as temporary. The central bank then has to tighten against the second-round process, not against the original oil, food, or import-price move. The 2021-2023 global inflation episode illustrated exactly this sequence: energy and food shocks layered on top of goods-supply bottlenecks, and the longer central banks attributed the episode to supply factors the more second-round wage and services pressures built ^[4].

Average inflation targeting promises that past misses matter for future policy. That can help after a long period below target because it makes the central bank less likely to tighten at the first sign of recovery. The Federal Reserve's 2020 framework review introduced flexible average inflation targeting explicitly to address the persistent below-target outcomes of the 2010s ^[5].

The same design becomes harder when inflation runs above target. The public has to believe that a flexible average target will still produce a return to price stability, not an open-ended tolerance for overshoots. The 2022-2023 hiking cycle was partly a test of whether the FAIT framework had durable credibility; that the Fed raised rates by more than 500 basis points without a decisive break in long-run expectations suggested the nominal anchor held, though the episode also exposed the asymmetric communication challenge of a make-up strategy.