The Hindu Business Line : Should inflation expectations drive monetary policy?

In recent times, it is not only concurrent inflation data, but also inflation prospects and expectations, which are widely commented upon by central banks, central bankers, economists and analysts.

It is, more or less, a philosophical issue.

How do you sculpt monetary policy and interest rates? Decades of research have failed to throw up any definite answer.

In fact, monetarists and non-monetarists cannot agree even on the starting point. The former group believes that price stability is the end-all and be-all while the latter camp thinks employment goals are also important.

This difference is sharply reflected in the divergent mandates of the European Central Bank (inflation target) and the US Federal Reserve (stable prices consistent with maximum sustainable employment).

Mr Ben Bernanke, the current Chairman of the Fed, is a known advocate of numerical price goals. Does it conflict with the Fed's employment - promoting objective?

Monetarists are, at any rate, very clear that a central bank should, by no means, be allowed to tailor its policies to anything other than inflation management.

This, of course, takes us to the age-old debate on central bank independence.

Conservatives have been at the forefront in demanding the separation of Governments and central banks.

Surprisingly, however, Ms Margaret Thatcher did nothing about it in her decade-long tenure nor did her successor, Mr John Major. It was left to Mr Gordon Brown, the present Labour Chancellor of the Exchequer, to award complete freedom to the Bank of England to decide interest rates within the framework of inflation targets. Thus, there is a broad consensus across the political spectrum on the importance of price stability.

In recent times, it is not only concurrent inflation data, but also inflation prospects and expectations, which are widely commented upon by central banks, central bankers, economists and analysts. Policy is, therefore, forward-looking, the idea perhaps being to nip inflation in the bud, well before it surfaces.

But how much weightage should a central bank attach to indicators of inflation expectations? Suppose bond yields go up because the market perceives the central bank is soft on inflation or commodity prices will pass-through to final prices. Should policy be dictated by such (possibly) entirely erroneous beliefs in the market? After all, markets have been very wrong many times in the past. There is no reason to think this will not continue into the future.

It is probably for this reason that Ms Janet Yellen, President of the Federal Reserve of San Francisco and an FOMC member, suggests that building credibility should be every central bank's mission.

Once that is established, it will serve as the capital to control inflation expectations. Policy need not be then mortgaged to the market's imaginary fears about inflation.

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