Steering Inequality: How Inflation Targeting Can Buffer the Social Impact of Monetary Policy

When central banks raise interest rates to combat inflation, one unintended consequence can be increased income inequality. Jamie Cross and Francisco Tavares Garcia addressed this key challenge in a new study examining the G7 economies over 45 years.

The Inequality Side Effect of Monetary Policy

When central banks raise interest rates to combat inflation, one unintended consequence can be increased income inequality. That’s the key challenge addressed by Jamie Cross (Melbourne Business School) and Francisco Tavares Garcia (University of Queensland) in a new study examining the G7 economies over 45 years. Using a rigorous structural vector autoregression (SVAR) model, the authors ask: can inflation targeting – where central banks publicly commit to a specific inflation rate – soften the unequal effects of monetary policy?

Their findings are striking. Across the G7, contractionary monetary policy shocks (i.e., interest rate hikes) typically widen income gaps. However, in countries with clear, country-specific inflation targeting regimes like Canada, the UK, the US, and Japan, these inequality effects either diminished or disappeared altogether post-adoption. The same could not be said for France, Germany, and Italy, which operate under the Eurozone’s collective inflation targeting framework.

Inflation Targeting: A Game Changer in Monetary Governance

Inflation targeting isn't just a technocratic tweak—it redefines how central banks interact with the economy. By splitting their analysis into periods before and after inflation targeting was adopted (based on specific historical timelines), Cross and Garcia show how the institutionalization of inflation targets moderates the social costs of monetary tightening.

For example, prior to adopting inflation targets in the early 1990s, countries like Canada and the UK experienced clear increases in inequality following rate hikes. After inflation targeting was implemented, these effects largely vanished. In Canada and the US, income inequality responses to rate shocks were no longer statistically credible. In Japan and the UK, the effects were still present but weakened.

This shift isn't merely academic—it implies that inflation targeting may anchor expectations and enhance the credibility of monetary policy in ways that protect lower-income households from disproportionate economic shocks.

Innovative Data Engineering for Economic Insights

A major contribution of the paper lies in its innovative data and analytics methodology. To make high-frequency econometric analysis possible, the researchers converted annual income inequality data from the SWIID database into quarterly series using the Chow–Lin temporal disaggregation method. This process allowed them to estimate dynamic responses of inequality to monetary shocks with greater precision, matching the frequency of macroeconomic indicators like inflation, GDP, and interest rates.

Moreover, their use of Bayesian methods and sign-restricted SVARs allowed for a flexible, theory-consistent estimation of monetary policy impacts without overly rigid assumptions. This approach reflects a broader trend in data analytics toward models that are both empirically grounded and economically interpretable.

From Theory to Practice: Why Business Leaders Should Care

For business executives and policy advisors, this research carries clear implications. First, it underscores the importance of monetary policy design in shaping the broader socio-economic landscape—not just in terms of inflation and growth, but also equity and inclusion.

Second, it suggests that countries with clear and credible inflation targeting regimes are better equipped to navigate economic shocks without exacerbating inequality. This matters for long-term social stability, consumer demand, and public trust in institutions—all of which influence the business environment.

Finally, for emerging markets or countries considering inflation targeting frameworks, this research provides compelling evidence that such policies can deliver both macroeconomic and social dividends—if tailored effectively.