Why Central Banks Target Interest Rates Instead of Directly Targeting Inflation

In understanding why central banks opt to target interest rates rather than directly targeting inflation, it is essential to first grasp the complexities inherent in both economic indicators and the mechanisms available to central banks.

Understanding Inflation and Central Banks

At its core, inflation is a reflection of a supply-demand imbalance within an economy and is not inherently a monetary phenomenon. In a nominally free market, central banks do not possess the capability to directly produce goods or services to counteract or create inflation. Therefore, the most viable approach is to influence the cost and supply of money.

Interest Rates: A Market-based Solution

Interest Rate Basics:

The interest rate is the price lenders charge for the money they create and lend, expanding the money supply and driving economic growth. The official definition of inflation is a broad measure of price fluctuations across a periodically adjusted and agreed basket of goods. Central banks control these prices indirectly by regulating money supply via interest rate adjustments.

In a functional market economy, central banks cannot target inflation directly. Instead, they focus on adjusting interest rates in response to economic conditions to combat and deter inflation without resorting to direct government intervention or wage and price controls.

Rising and Lowering Interest Rates: Market-Based Control

By raising or lowering interest rates, central banks influence the cost of borrowed money. If interest rates are high, debtors are less inclined to take on new loans, reducing the amount of new spendable money entering the economy. Conversely, when interest rates are low, more debtors are willing to take out loans, stimulating production and helping to prevent deflation.

Historical Context: Reserve Requirements

Prior to the early 1990s, Western central banks employed a more direct approach to controlling the money supply through reserve requirements. In this model, central banks would create reserve account balances in commercial banks’ reserve accounts. Higher reserves would limit the amount of credit that commercial banks could create, while reducing reserve requirements would allow for greater credit expansion.

Commercial banks create bank deposits through loans, which form the spendable money supply. When a debtor pays a bank deposit, the paying bank debits its reserve account and credits the receiving bank’s reserve account, ensuring that the commercial bank has the liquidity to fulfill payment obligations. If a bank runs out of reserves, it can buy currency from the central bank to replenish its liquidity.

Limitations and the Role of Governments

The only way to directly target inflation would be through wage and price controls, which are typically implemented by governments rather than central banks. By making it illegal to increase wages and prices, governments can legally prevent price inflation, although such controls can be complex and inflexible.

Central banks act as independent mechanisms designed to regulate the supply of money for the long-term economic benefit of the wider economy. Their role is to use economic indicators such as inflation to guide their decisions, ensuring that monetary policy aligns with broader economic goals without being swayed by political pressures.

In conclusion, central banks target interest rates rather than directly targeting inflation because of the limitations in their ability to control supply through direct production, and because interest rate adjustments provide a more flexible and market-based approach to managing the economy's money supply and inflation rates.