It has been widely accepted in the literature that interest rates are the main instrument
of inflation targeting by central banks. They set up the transmission mechanism of their
monetary policy is such a way that the public are well-informed as to where the central bank is
heading with regard to future inflation targets, and interest rates are the most readily
observable variable in the market. Furthermore, central banks also use this monetary instrument to
obtain feedback from the public. A well-accepted response by the public is a good indication
for the bank that it should continue its current policy. On the other hand, when public
sentiment changes, it may be an indication for the bank to find an alternative approach that
reflects the change in public reaction.
A central bank that adopts inflation targeting is more concerned with measures to
contain domestic inflationary pressures, rather than reacting to inflation deviation. This means
that the central bank should pay more attention to the issue of isolating shocks that might
affect the achievement of long-run inflation targets negatively. That is also why many central
banks around the world do not react excessively to short-term fluctuations in the market, as
they tend to focus on long-term outcomes (Bernanke and Mishkin, 1997). However, banks
do use short-term interest rates as a way of influencing long-term price levels in
order to achieve their predetermined targets. In the mean time, inflation expectations
play a very important role in the monetary policy-making process. These provide the
central bank with critical information regarding the public's expectation of future
price movements. Accordingly, understanding the relationship between inflation expectations
and interest rate policy is very important, especially as both the variables are directly related
to the achievement of the ultimate objective of monetary policy, i.e., a low and stable
inflation rate in the long run. |