May 20, 1997
"Inflation Guideposts are Worth a Try"
San Jose Mercury News
By Timothy Taylor
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WHEN TONY BLAIR was elected the first Labor prime minister of Britain in the last 18 years, his party's first major step was to give up a powerful tool of economic policy -- the power to set interest rates. The United States could learn from his example.

In Britain, the prime minister and the appointed chancellor of the exchequer have long had the power to tell the Bank of England whether to raise or lower interest rates. The U.S. equivalent would be if Bill Clinton and his Treasury secretary could dictate how the Federal Reserve should set interest rates. However, Blair's chancellor of the exchequer, Gordon Brown, announced that in the future, Britain's government will only set a target for inflation, and the Bank of England would be responsible for deciding when interest rates needed to be moved to meet that target.

This policy of ''inflation targeting'' is experiencing an international boomlet. In the 1990s, Australia, Canada, Finland, Israel, New Zealand, Spain, and Sweden have all moved in this direction.

The first concern about inflation targeting is raised by those who favor lower interest rates as a way of stimulating the economy. They fear that a central bank obsessed with an inflation target will keep interest rates too high. But this fear is largely based on a misconception that the Federal Reserve, or any central bank, can use low interest rates to create permanently faster growth. Instead, the long-term rate of economic growth is determined by factors like the size, education and experience of the workforce, and the quantity and technological sophistication of the capital invested. A central bank which tries to put the economy on steroids with super-low interest rates and a rapidly growing money supply will simply cause inflation.

It is true that in the short term, a central bank can use lower interest rates to goose an economy out of recession. But the inflation targeting laws around the world allow central banks some short-term flexibility for this purpose. For example, they often set a target for inflation that is several percentage points wide, with certain well-defined escape hatches.

A second concern is that an independent central bank is undemocratic. This complaint has an element of truth; having the Federal Reserve or the Bank of England deciding on interest rates is certainly not the same as having elected officials, or a public referendum, decide when to take such a step. But in all large countries, democratic control is exercised indirectly, through elected representatives who pass general laws that are interpreted and enforced by political appointees, career bureaucrats and judges. From this perspective, America's present law governing the Federal Reserve is especially squishy. It tells the Fed in general terms to fight inflation and unemployment, but without offering any numerical guidance as to targets, or as to what are allowable. This is independence without accountability. In the hands of Alan Greenspan, a fine central banker, this discretion has worked well. But it would be imprudent to assume that all future central bankers will be equally competent.

An inflation-targeting law for the United States would be an advance in holding the Fed accountable. The economic benefits of such a law are more subtle. One main difficulty in conducting monetary policy is that it takes about two years for changes in interest rates to filter through the overall economy and have a significant effect on business borrowing for investment and household borrowing for homes and cars. Meanwhile, politicians often want to stimulate the economy this week. Thus, countries with a high degree of political control over monetary policy, like Britain, have tended to face a situation where over eager politicians overstimulated the economy, and brought on inflation instead.

Inflation targeting laws are a balancing act that allow democratic institutions to specify the goals and conditions for low inflation, and then direct the central bank to take a medium-term view, with the political insulation and independence to act when necessary.

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