A central bank needs a nominal anchor — something to tie down the price level and inflation expectations, so that money has a stable value. There are three classic anchors, and the choice among them is one of the most consequential decisions in monetary policy. This module covers the three frameworks, the rise of inflation targeting as the modern standard, and why African central banks so often run a hybrid that fits neither textbook box.
Three nominal anchors
- Monetary targeting — target the growth rate of a money aggregate (M2, M3), on the monetarist logic (Friedman) that inflation is 'always and everywhere a monetary phenomenon'. Its fatal flaw: it works only if the demand for money is stable and predictable, which it usually is not (financial innovation, mobile money, and shifting velocity break the money-inflation link), so most countries abandoned it.
- Exchange-rate targeting — peg the currency to a stable foreign anchor (the dollar, the euro), importing the anchor country's price stability. Simple, transparent, and credible — but it surrenders monetary independence (the trilemma, module 6), can leave the currency misaligned, and is vulnerable to speculative attack and crisis (the currency-crisis material of the International Macro course).
- Inflation targeting — announce an explicit numerical target for inflation and use all instruments (chiefly the policy rate) to hit it, with the inflation forecast as the guide. The dominant modern framework, adopted by New Zealand (1990) first and now dozens of countries including South Africa and Ghana.
The components of inflation targeting
What makes a regime 'inflation targeting'
Bernanke and Mishkin (1997) identify the elements: • An explicit, announced numerical inflation target (a point or range, e.g., 5% ± 2.5%). • Price stability as the primary, legally-recognised goal, with the institutional commitment and independence to pursue it. • A forward-looking, forecast-based approach — because policy acts with long lags, the bank targets the FORECAST of inflation over the policy horizon, not today's inflation. • Transparency and accountability — regular inflation reports, published forecasts and reasoning, and accountability for hitting the target (the counterpart to independence from module 1). The anchor is the target itself plus the bank's credible commitment to it: if everyone believes the bank will deliver 5% inflation, expectations settle at 5% and the bank's job is largely done. Inflation targeting is, at bottom, the management of expectations.
Flexible inflation targeting
Pure ('strict') inflation targeting would care only about inflation. In practice all inflation targeters are flexible: they aim to return inflation to target over a medium-term horizon while also stabilising output and avoiding excessive volatility in interest rates and the exchange rate. This is captured by the idea that the bank minimises a loss function weighting both inflation deviations and the output gap (the modern New Keynesian framework). Flexibility matters especially for supply shocks (a fuel-price spike raises inflation and lowers output simultaneously, the next module's problem): a strict targeter would crush output to hit the inflation number immediately; a flexible one looks through the temporary spike and returns inflation to target gradually, balancing the two goals. Flexibility is what makes inflation targeting workable in a shock-prone economy.
Why African frameworks are hybrid
De jure inflation targeting, de facto eclectic
Many African central banks describe themselves as moving toward inflation targeting, yet in practice run a hybrid, eclectic framework: they watch inflation, but also pay close attention to monetary aggregates AND heavily manage the exchange rate, without committing fully to any single anchor. The Central Bank of Kenya is a fair example. Why the hybrid? Because the preconditions for textbook inflation targeting are only partly met: transmission is weak (last modules), so the policy rate is a blunt tool; the exchange rate matters enormously for inflation (high pass-through, so the bank cannot ignore it — but managing it compromises the interest-rate anchor, the trilemma); data are poor and lagged, making forecast-based targeting hard; and credibility is still being built. So the bank hedges, using several partial anchors at once. This is not necessarily a failure — it can be a sensible adaptation to the constraints — but it does mean the framework is less transparent and the anchor less sharp than the inflation-targeting label suggests. Reading what an African central bank actually does, rather than what it calls itself (the de jure/de facto distinction of the Governance course), is essential.
Exercise
A central bank in a developing economy with weak transmission, high exchange-rate pass-through, and unstable money demand is deciding its monetary framework. (1) Assess each of the three anchors for this economy, with the key drawback of each. (2) Explain why pure inflation targeting is hard here, and what 'flexible' inflation targeting would add. (3) Explain how a fuel-price shock would expose the difference between strict and flexible targeting. (4) Explain why the bank might rationally end up with a hybrid framework, and the cost of that choice.