What is inflation targeting?

Inflation targeting is a monetary policy framework in which a central bank publicly announces a numerical target for inflation and uses its policy instruments, primarily the short-term interest rate, to achieve that target over a defined time horizon. The Federal Reserve formally adopted a 2% inflation target measured by the PCE price index in January 2012, though it had informally operated with a similar objective for years prior.

The framework rests on the theory that a credible, transparent inflation target anchors the inflation expectations of households, businesses, and financial markets. When economic actors believe that inflation will average 2% over time, they set wages, prices, and investment plans accordingly, creating a self-reinforcing equilibrium. This anchoring effect is arguably more important than any specific interest rate decision because it keeps the inflation process stable without requiring constant central bank intervention.

New Zealand was the first country to adopt formal inflation targeting in 1990, followed by Canada, the UK, and eventually most major central banks. The standard 2% target emerged as a consensus for several reasons. Zero percent was considered too close to deflation, which carries severe economic risks. Higher targets would impose unnecessary costs on fixed-income savers and create more price uncertainty. Two percent was seen as providing sufficient buffer above zero while maintaining price stability.

In August 2020, the Fed shifted to "flexible average inflation targeting" (FAIT), meaning it would seek inflation that averages 2% over time rather than targeting 2% at every moment. This allowed the Fed to tolerate periods of moderately above-2% inflation following periods where inflation had run below target, as it had for most of the 2010s. The FAIT framework proved controversial when inflation surged in 2021-2022, with critics arguing it delayed the Fed's tightening response. Whether the framework survives its first real test or is revised remains an active debate among monetary economists.