How Are Inflation Targets Set?

This paper contributes to a better understanding of how inflation targets are set. First, we gather evidence on how inflation targets are set from official central bank and government publications, and from a questionnaire of our own design. Second, we estimate what determines the level of the inflation target in 19 inflation-targeting countries by using unbalanced panel interval regressions to deal with the issue that targets are typically set as a range rather than a point. We find that a higher target is associated with a higher level and variability of inflation. The setting of the inflation target is also found to have an important international dimension because higher world inflation is positively correlated with inflation targets. Rapidly growing countries exhibit higher inflation targets. Our results also show that authorities establish a wider target range for the inflation rate when the macroeconomic environment is less stable. We find that central bank credibility is negatively associated with the level of the inflation target, suggesting that less-credible central banks are likely to recognize the risks related to anchoring inflation expectations at low levels. On the other hand, government party orientation does not matter, even in less-independent central banks.