Thursday, July 17, 2008

For inflation targeting

Ajay Shah has yet another article on India's inflation. Here's an important one-liner,
Professional economists agree with professional politicians on the importance of low inflation.
I think that sums up the case for inflation targeting.

I have previously been an advocate of currency boards, as the best institutional reform we can go for in the face of spiraling inflation in Sri Lanka, joining the camp of guys like Fuss-Budget and Steve Hanke. I have since changed my views, not so much because I have suddenly have faith in Sri Lankan institutions. I still think they are crap and I have have knee-jerk sympathy for abolishing government institutions (in this case, the central bank). But I think inflation-targeting regulation would better stand the political economy test than currency boards.

As Ajay points out, in this rare case, both politicians and economists (and the general public) agree on something -- low inflation is good. So a mandated low-inflation target for the central bank should be workable.

But I digress. This is the same country which removed inflation alcohol from the CPI index due to moral reasons and has perhaps the only central bank chief who thinks of more than a 9% of 'Core inflation' as being rather low. If there is an inflation target, perhaps the Central Bank would resort to Index manipulation. I guess I am taking a leap of faith afterall.

Despite that, I don't think abolishing the central bank will hold very well with both the electorate and most political parties. I can already hear the JVP and other lefties shouting that our monetary policy is set by Washington (in the case of a dollar-pegged currency board, this might actually be true!). Also, as the currency spate of monetary expansion in the U.S. shows currency boards are not without their problems.

Inflation-targeting on the other hand goes well with most economists I have met and seems to have stood the test of time globally, assuming it survives the current commodity hike. Realistically, this might be the best institutional reform we can get.

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