The main attributes of inflation targeting
In the pursuit of its primary monetary policy objective , i.e. maintaining price stability, the central bank can opt for any one of several monetary policy regimes. The four basic types of regime are:
(1) a regime with an implicit nominal anchor,
(2) money targeting,
(3) exchange rate targeting,
(4) inflation targeting.
In December 1997, the CNB Bank Board decided to change its monetary policy regime and at the start of 1998 it switched to inflation targeting. This did not involve any change in objective, only in the way of achieving this objective.
The main features of inflation targeting are its medium-term focus, the use of an inflation forecast and the explicit public announcement of an inflation target or sequence of targets. In its monetary policy decision-making the CNB Bank Board assesses the latest CNB forecast and evaluates the risks of non-fulfilment of this forecast. Based on these considerations the Bank Board then votes on whether and how to change the settings of monetary policy instruments. By changing these instruments the central bank seeks to offset excessive inflationary or disinflationary pressures which are deviating future inflation from the inflation target or from the tolerance band around this target. For example, an increase in the repo rate generally leads, via the transmission mechanism, to a weakening of aggregate demand, which in turn causes inflation to fall. Lowering the repo rate generally has the opposite effect. If the central bank expects that inflationary effects deviating inflation above the targeted value will prevail in the future, this is a signal that monetary policy should be tighter, i.e. that the repo rate should be raised.
Inflation, or expected inflation, can, however, result from extraordinary shocks – as a rule on the supply side – whose inflationary or disinflationary effects unwind over a period of time. Any attempt to entirely offset these effects by changing the settings of monetary policy instruments would needlessly cause short-term fluctuations in the economy. If the inflation forecast moves outside the inflation target tolerance band for a time due to such shocks, this is usually regarded under inflation targeting as an exemption from the central bank's objective of keeping inflation close to the target. The CNB – like many other inflation-targeting central banks – has adopted this practice and in justified situations works with "caveats", i.e. exceptions from its obligation to hit the inflation target.
a) The CNB´s inflation targets set in terms of net inflation:
|Year||Target level||Target month||Set in|
|1998||5.5% – 6.5%||December 1998||December 1997|
|1999||4% – 5%||December 1999||November 1998|
|2000||3.5% – 5.5%||December 2000||December 1997|
|2001||2% – 4%||December 2001||April 2000|
|2005||1% – 3%||December 2005||April 1999|
b) Target band set in terms of headline consumer price inflation for the January 2002 – December 2005 period:
|Month||Target level||Target month||Set in|
|Band starts||January 2002||3% – 5%||January 2002||April 2001|
|Band ends||December 2005||2% – 4%||December 2005|
c) The inflation target was set in terms of headline inflation of 3% with effect from January 2006 to December 2009.
d) An inflation target set in terms of headline inflation of 2% is valid from January 2010 until the Czech Republic's entry to the euro area.
Despite the fact that the CNB strives to keep future inflation at the 2% target all the time, actual inflation deviates from this value due to unexpected shocks. Although monetary policy reacts to these shocks and aims to ensure that the point target is achieved in the future, it is unable to return inflation to 2% immediately. This uncertainty is illustrated by a tolerance band of one percentage point in either direction.
The CNB's inflation targets
In the initial period of inflation targeting, the Czech National Bank used "net" inflation as its main analytical and communicative indicator of inflation. The CNB's medium-term inflation target for end–2000 was announced at the same time as the switch to inflation targeting, i.e. in December 1997. The central bank committed itself to employing its monetary policy instruments so as to achieve annual net inflation within the 3.5%–5.5% range at the end of 2000. To better anchor inflation expectations, the CNB also announced a target range for net inflation of 5.5%–6.5% for end–1998. In November 1998, a short-term net inflation target range of 4%–5% was set for end–1999.The CNB Monetary Strategy document published in April 1999 formulated a long-term objective of price stability in terms of net inflation within the 1%–3% range for end–2005. In April 2000, a target was set for end–2001 (see the accompanying document: The Setting of the Inflation Target for 2001 (pdf, 114 kB)). In April 2001, a decision was made to switch to targeting headline inflation (i.e. growth in the total consumer price index) and to expressing the target trajectory for headline inflation by means of a continuous band. A band was announced starting in January 2002 at 3%–5% and ending in December 2005 at 2%–4% (see the accompanying document: The Setting of the Inflation Target for 2002–2005 (pdf, 36 kB)). An inflation target of 3% with a tolerance band of one percentage point in either direction was announced for the period from January 2006 (see the accompanying document: The CNB's inflation target from January 2006 (pdf, 76 kB)). In March 2007, a new inflation target of 2% was announced with effect from January 2010. As before, the CNB communicates an uncertainty band of one percentage point in either direction around this point target (see the accompanying document: The CNB's new inflation target and changes in monetary policy communication).
The CNB bases its assessment of the inflation trend on the statistical data published by the Czech Statistical Office. The inflation outturns – which, within the inflation targeting regime, form the basis for both the conduct and retrospective assessment of monetary policy – are thus published by an institution independent of the CNB. This arrangement enhances the credibility of inflation targeting.
Exceptions from achieving the inflation target (caveats/escape clauses)
In the inflation targeting regime, the need for escape clauses derives from the occurrence of large shock changes in exogenous factors (particularly supply-side shocks) that are completely or largely outside the purview of central bank monetary policy. Attempts to keep inflation on target in these circumstances might cause undesirable volatility of output and employment. If such a shock deflects projected inflation from the target, the CNB does not respond to the primary impacts of the shock. It will apply an exemption (escape clause) from the obligation to hit the inflation target and accept the temporary deviation of the inflation forecast and consequently also future inflation from the target caused in this way. There is a whole range of shocks which can create room for applying such escape clauses. Changes to indirect taxes are one such shock.
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