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Is price stability violated when inflation deviates from the target?

The NBU has set Ukraine’s medium-term inflation target at 5%. This does not mean, however, that actual inflation will stay at this level for months. The main indicator of whether a central bank's monetary policy has succeeded is the situation in which expectations of future inflation are low and stable, rather than when actual inflation is at the target level. The reasons are outlined below.

It often happens that due to certain factors, in particular those not related to the activities of the central bank, inflation deviates from the stated benchmark. In this case, however, the most important fact is that the public and investors know what to expect from the central bank. They understand that monetary policy (more expensive or cheaper money) will be aimed at returning inflation to the target, and that the central bank will achieve the target eventually.

Confidence in the central bank’s ability to meet the target contributes to the public’s and businesses’ expectations that future inflation is close to the target set by the central bank.

Why are inflation expectations so important?

Central banks attach great importance to ensuring that inflation expectations are stable and close to the target, as this benefits the economy in a number of ways.

Inflation is easier to control. Inflation expectations are a factor in the formation of price trends. For instance, a worsening of inflation expectations may accelerate the growth of consumer demand for goods, which, in turn, stimulates price growth. Manufacturers that expect higher prices for raw materials and equipment may also raise their product prices today to offset future losses. Thus, in order to influence inflation, the central bank should influence inflation expectations.

Banks charge lower interest rates. Stable inflation expectations are a key to lowering interest rates on bank loans. Depositors will not take their money to banks if interest rates on bank deposits fall short of covering their inflation expectations. Banks compensate for the increase in deposit rates by charging higher interest rates on loans. Thus, banks’ loan rates depend less on actual inflation than on inflation expectations.

Stable inflation expectations create a favorable decision-making environment. Inflation expectations affect investment and savings decisions. Low inflation expectations increase confidence in the domestic currency. This stimulates the transition to long-term investment, which spurs economic growth.

Central banks that effectively manage inflation expectations follow a simple rule: “Say what you do and do what you say.”

Say what you do

To reduce and anchor inflation expectations, central banks aim to raise public awareness of their monetary policy decisions and promote confidence in these decisions.  To that end, the central bank should make its objectives clear and avoid changing them. That also requires a transparent decision-making system. The central bank should make it clear who makes decisions, how these decisions are made, and why they are made.

The NBU has come a long way in terms of transparency. The long-term goals and principles of the NBU’s monetary policy are defined by its Monetary Policy Strategy. Identifying and communicating long-term goals is necessary, as the road to gaining public confidence in monetary policy objectives is long. The NBU cannot travel this road if it changes its goals and the “rules of the game” required to achieve them.

The NBU communicates all of its monetary policy decisions both through traditional channels, including press briefings, press releases, and other publications on its official website, as well as through Facebook, Twitter, YouTube, and Instagram. The NBU regularly publishes the meetings and interviews of its executives, as well as meetings between NBU executives and businesspeople, academics, journalists, and university students.

Do what you say

An important prerequisite for reducing inflation expectations is the central bank’s commitment to meet the inflation target.

As the central bank does not have direct control over prices, and monetary transmission works with a lag, monetary policy is always aimed at the future. When making monetary policy decisions, the NBU is guided by the inflation forecast.

If prices come under increased pressure, the NBU raises the key policy rate. By doing so, it implements the “expensive money” policy necessary to return the projected inflation rate to the target. When instead the factors that can lead to extremely low or negative inflation dominate, the NBU cuts the key policy rate. Thus, inflation should always approach the target over the forecast horizon.