A framework in which the central bank commits to a numerical inflation goal, usually 2%, and sets policy to return inflation to it over the medium term.
Targeting works through expectations. If firms and households believe inflation will come back to 2%, they set prices and wages accordingly, which makes the belief self-fulfilling and does most of the central bank's work for it.
Average inflation targeting adds a memory: after a period of undershoot the bank aims to overshoot modestly so that the average lands on target. That makes long-run inflation-expectations the variable to watch, because if they drift the framework has failed regardless of the current print.
Example: the target is 2% on the pce-price-index. Five-year five-year forward breakevens sit at 2.25%, roughly consistent with target once the CPI-PCE wedge of about 0.3 percentage points is allowed for.
Original diagrams for the ideas on this page. Illustrative, not real market data.
Risk and reward on one trade. One trade on a price scale: the entry sits 2.00 points above the stop and 6.00 points below the target, so the shaded reward band is three times the risk band. The ratio compares what is lost if the stop is hit with what is gained if the target is reached.
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