Flexible Inflation Targeting Framework
This subsection describes the Central Bank’s approach to monetary policy, known as flexible inflation targeting, where the central bank seeks to achieve price stability over a medium-term horizon rather than on a period-by-period basis. Flexible inflation targeting ensures that price stability is achieved without undue economic and financial instability. It provides a sensible approach for responding to economic shocks, and reflects the fact that policy takes time to transmit through the economy.
Maintaining a constant inflation rate of 3 percent at all times is not feasible or desirable. The CBA practices flexible inflation targeting, which means that it sets monetary policy in a way to achieve its price stability goals in the medium term (understood to be a one to three year horizon). The CBA does not attempt to return inflation to the target immediately and does not target CPI inflation on a period by period basis. This is due to a number of reasons. First, monetary policy actions take time to transmit through the economy. Second, attempting to bring inflation back to the target in too short a timeframe would result in undue economic and financial instability. Finally, because the economy is dynamic, it is subject to a number of shocks that are beyond the central bank’s control. These include supply-side shocks to global commodity markets, food prices, and so on, which are beyond the reach of monetary policy and are expected to be temporary in nature. The CBA would respond to these types of disturbances only in the event that there are risks that inflation expectations would rise and impact the CBA’s ability to achieve the inflation target in the medium term.
Taken together, this approach to monetary policy is known as flexible inflation targeting. While the CBA defines a point objective of 3% year-over-year CPI inflation in the medium-term, we also recognize the importance of the considerations noted above. The relevant legal acts thus allow for a variation band of ±1.0 percentage points target to account for these factors.
Moreover, flexible inflation targeting provides a basis for economic agents and the general public to credibly agree that any deviations from the inflation target are temporary. Because the central bank has a robust policymaking framework in place to achieve flexible inflation targeting, agents can be confident that their expectations of inflation in the medium- and long-term would not need to adjust in response to short-term or temporary changes in prices.
Central banks can choose different monetary regimes to reach their price stability objectives. These include inflation targeting, exchange rate targeting, monetary aggregate targeting, and so on. Since January 2006, the CBA has practiced an inflation targeting strategy. Inflation forecasts were set as an intermediate target (the discrepancy between the forecast and the inflation target prompts policy choices to close the gap). The short-term interest rate was set as an operational objective. The CBA is independent to choose its monetary policy strategy, intermediate and operational targets.