Page 774 - The Principle of Economics

796 PART THIRTEEN FINAL THOUGHTS
IN THE NEWS
Inflation Targeting
DURING THE 1990S, MANY CENTRAL BANKS around the world adopted inflation targeting as a rule—or at least as a rough guide—for setting monetary policy. Brazil is a recent example.
Brazil to Use Inflation Data for Managing Interest Rates
BY PETER FRITSCH
RIO DE JANEIRO—Brazil’s Central Bank will adopt in late June a formal process for managing interest rates based on predefined inflation targets for the fol- lowing 30 months, according to the
bank’s president, Arminio Fraga.
In an interview, Mr. Fraga said the Central Bank is in the process of work- ing out the details of an “inflation target- ing” regime for managing interest rates and the economy. Inflation targeting— a system used by other countries with free-floating currencies such as Britain, Canada, and New Zealand—is fairly sim- ple: If prices are rising faster than expec- tations, interest rates are lifted to cool off the economy. If prices are falling or steady, rates are cut. . . .
Once in place, Brazil’s new policy will look like the Bank of England’s. Britain’s central bank hitched interest- rate policy to a more visible price anchor after the inflationary shock of the pound’s severe weakening in 1992. To- day, the United Kingdom targets annual inflation at 2.5% over a two-year horizon and adjusts short-term interest rates when its price forecasts wander from that goal by more than a percentage point.
In general, outside observers like the simplicity of this policy. “The ad- vantage of targeting inflation is that the Central Bank is less likely to
micromanage than if it is trying to target the level of interest rates or the cur- rency,” says Morgan Stanley Dean Wit- ter & Co. economist Ernest W. Brown. The downside of setting explicit targets is that a hard-to-predict economy without price controls like Brazil’s is apt to miss its inflation targets from time to time, and miss them publicly.
That causes some to worry about the Brazilian Central Bank’s lack of inde- pendence. Brazil’s Central Bank reports to the Finance Ministry, and thus to the president. What if missing—or hitting— an inflation target clashes with other ad- ministration goals, such as reducing unemployment? “Inflation targeting goes in the right direction of trying to insulate the Central Bank from politics,” says J. P. Morgan & Co. economist Marcelo Carvalho. “Still, introducing inflation tar- geting without proper formal Central Bank independence risks just pouring old wine into new bottles.”
SOURCE: The Wall Street Journal, May 22, 1999, p. A8.
CON: MONETARY POLICY SHOULD NOT BE MADE BY RULE
Although there may be pitfalls with discretionary monetary policy, there is also an important advantage to it: flexibility. The Fed has to confront various circum- stances, not all of which can be foreseen. In the 1930s banks failed in record num- bers. In the 1970s the price of oil skyrocketed around the world. In October 1987 the stock market fell by 22 percent in a single day. The Fed must decide how to re- spond to these shocks to the economy. A designer of a policy rule could not possi- bly consider all the contingencies and specify in advance the right policy response. It is better to appoint good people to conduct monetary policy and then give them the freedom to do the best they can.
Moreover, the alleged problems with discretion are largely hypothetical. The practical importance of the political business cycle, for instance, is far from clear. In some cases, just the opposite seems to occur. For example, President Jimmy Carter appointed Paul Volcker to head the Federal Reserve in 1979. Nonetheless, in