Why inflation targeting?
Like the Riksbank, most central banks around the world focus on maintaining inflation at such a low and stable rate that it doesn’t enter into households’ or firms’ decision-making. This creates conditions for favourable economic developments for several reasons. What follows below is a short description of some of the reasons why high, variable inflation poses a problem.
Affects the use of resources
Increases in the prices of individual goods are usually referred to as relative price changes, and these contain important information about where economic resources are best put to use. Relative price changes occur continuously in an economy and are fairly easy to discern if inflation is low. If inflation is high, however, it is difficult to know whether an increase in the price of an individual good is a relative price change or part of a general rise in prices. This may cause households and firms to make decisions on the basis of incorrect information. Low, stable inflation enables the price mechanism to work most effectively and leads to an efficient use of resources.
Leads to greater uncertainty and higher borrowing costs
When inflation is high, it is more likely to fluctuate than when it is low. This increases uncertainty about the future. When the level of uncertainty is high, savers and borrowers demand an insurance against a reduction in the future value of their money. This insurance is called a risk premium and results in higher interest rates. Higher interest rates make it more expensive to borrow, which can hamper investment.
Makes long-term planning more difficult
When firms plan their activities they need answers to several questions. By how much will costs increase? What prices should we charge to be sure of generating a profit? Will wages rise? All of these questions are more difficult to answer under conditions of high, fluctuating inflation compared with conditions where inflation is low and stable. As a result, firms may refrain from investing in new products and machinery.
Affects the distribution of income and wealth
Inflation affects the distribution of income and wealth between different social groups. High inflation benefits some groups more than others. For example, it becomes less profitable to save in a bank account since the money deteriorates in value. On the other hand it benefits borrowers, since their loans also drop in value.
More information about the Swedish experiences of inflation targeting can be found in the below speech held by Lars Heikensten. The box presents an outline of the problems associated with deflation, or a fall in the general level of prices.