Almost every major central bank has a number it lives by: its inflation target. In the UK, US and eurozone it is 2 per cent. In Australia it is a range of 2 to 3 per cent. These targets shape interest rate decisions, bond yields, currencies and ultimately the cost of mortgages and loans. For beginners, understanding the inflation target is the key to understanding why central banks do what they do.
What an inflation target is
An inflation target is the rate at which a central bank aims to keep the general rise in prices over time. Inflation is usually measured by a consumer price index, which tracks the cost of a typical basket of goods and services. If the index rises 2 per cent over a year, inflation is 2 per cent.
The Bank of England’s target is set by the government at 2 per cent, measured by the Consumer Prices Index (CPI). If inflation moves more than one percentage point away from target, the Governor must write a letter to the Chancellor explaining why and what the Bank is doing about it.
Why 2 per cent and not zero?
A small, steady amount of inflation is considered healthy. It gives central banks room to cut interest rates in a downturn, makes it easier for wages and prices to adjust, and guards against deflation, a damaging spiral of falling prices that can lead people to delay spending. Two per cent has become a widely accepted compromise between price stability and flexibility.
How the target drives interest rates
When inflation runs above target, central banks tend to raise interest rates to cool demand. When it runs below target, they tend to cut rates to encourage spending. Because rate changes take a year or more to have their full effect, central banks act on forecasts of inflation, not just the latest figure.
This week the Reserve Bank of Australia raised rates again, with its forecasts reportedly showing inflation not returning to its target range until late 2027, partly because of fuel costs. Our Morning Market Brief covered the decision.
Why markets care about every inflation release
Because the target guides policy, each inflation number shifts expectations for interest rates. A higher-than-expected reading can push bond yields up and the currency higher as traders bet on tighter policy. A lower reading can do the reverse. That is why inflation days are among the most volatile on the calendar.
Headline versus core inflation
Central banks watch headline inflation, which includes everything, and core inflation, which strips out volatile items such as food and energy. Energy shocks, like a spike in oil, can push headline inflation well above target while core inflation moves more slowly. Central banks try to judge whether such shocks will feed into wages and broader prices before reacting. Our guide on how oil prices affect gilt yields follows that chain.
What happens when targets are missed
Missing the target for a long time can damage a central bank’s credibility. If people stop believing inflation will return to 2 per cent, they may demand higher wages and raise prices in anticipation, making inflation harder to control. That is why central banks sometimes act more aggressively than the economy seems to need.
The takeaway
The inflation target is the anchor for central bank decisions. When you understand where inflation is relative to target, and where it is forecast to go, interest rate moves become far more predictable.
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