Why inflation targeting?

Like the Riksbank, most central banks around the world focus on maintaining inflation at a low, stable rate that households and firms can rely on when making economic decisions. 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. 

High, variable inflation:

Greater uncertainty and higher borrowing costs

When inflation is high, the risks increase of a more varied inflation trend compared with conditions where it is low. This increases uncertainty about how prices will develop in 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 and thereby activity in the economy. 

Makes long-term planning more difficult

When firms plan their activities they need answers to various questions. By how much will costs increase? How much should we charge in order to generate 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 groups in society. High inflation benefits some groups at the expense of 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. The central wage agreements normally apply over a longer period, that is 2-3 years. If inflation is higher than was assumed when the agreements were negotiated, wage-earners’ incomes will be undermined.

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, say, the price of oil rises merely as a result of oil becoming scarcer, this is a rising relative price which contains important information. It may be profitable for firms to make certain investments that entail less use of the scarce resource. However, if all prices rise at the same rate it is harder to decide if the oil price increase is a rising relative price or part of an inflation process. By keeping inflation low and stable it is easier to interpret the information available in the prices changes and in that way to decide how the economy’s resources are to be employed.

 

More information about the Swedish experience of inflation targeting can be found in the article below. The boxed text presents an outline of the problems associated with deflation, or a fall in the general price level.

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