On June16, Mervyn King, the governor of the Bank of England (BoE, the UK central bank), wrote a letter to the Chancellor of the Exchequer, Alastair Darling, which was placed on the bank's website. It is unlikely that King was particularly keen to write the letter since it is effectively a public admission that the UK's monetary policy had failed to deliver its remit.
The bank's remit is to keep the inflation rate at or below 2 per cent. King's terms of contract compel him to write this public letter if the actual inflation rate exceeds the target by one percentage point. The May Consumer Price Index for the UK printed at 3.3 per cent.
Across the channel, King's counterpart, Jean Claude Trichet, President of the European Central Bank, has a similar problem. Fortunately for him, he is not forced to give a public explanation.
The euro-zone, too, has an official inflation target of 2 per cent and that the current inflation rate is almost double that at 3.7 per cent. Both the UK and euro-zone have explicit inflation targets, unlike the US Federal Reserve or the RBI.
The recent financial crisis and the episode of high inflation that has followed have seriously undermined some of the tenets of central banking. Concerns about the 'moral hazard' of bailing out truant banks have fallen by the wayside as the US Fed and the BoE have gone out on a limb to rescue banks like Bear Stearns and Northern Rock.
While the markets have punished financial institutions for their weak balance sheets by squeezing their liquidity lines, central banks have been happy to offer cash against the dodgiest of collaterals.
Inflation targeting as a policy stance has also come under the scanner. The BoE seems to be jettisoning it, at least temporarily. As King writes in this public letter, "If Bank rate (the BoE's policy tool) were to bring inflation back to the target within 12 months, the result would be unnecessary volatility in output and employment."
The European Central Bank might not have cut interest rates for a while but if it had been serious about meeting its targets, their policy rate should have been a good one percentage point higher.
What does this mean for the rules of the monetary policy game going forward? What should the remit of central banks be? Is the idea of inflation targeting flawed? Those who argue against a strict rule-based approach to monetary policy would use the current situation to buttress their case. Their argument could be the following.
One, inflation 'targeters' like the UK and Europe have not done better at keeping headline inflation down in the current phase compared to economies like the US that do not have a defined inflation mandate.
Two, if a monetary policy model has to be abandoned when an extreme situation arises (as the BoE seems to be doing) and central bankers have to fall back on discretion in setting policy, is there much point in having a target in the first place?
I would argue against this. For one, there is little doubt that the turn of events over the past few months has been truly exceptional. Inflation targeting does not imply absolute inflexibility in the face of a crisis.
Exceptional situations need out-of-the-box responses and the inflation targeting model does not have a problem with this. The question is: What should monetary authorities do as the crisis abates?
My sense is that when things return to 'normal' central banks need to assert their inflation-fighting credentials more than ever. For two reasons. First, it is likely that while oil and commodity prices will abate going forward, the second round or 'pass-through' effects will linger keeping headline inflation high.
We could thus be at the beginning of a prolonged phase of high inflation and rising inflation expectations. The only way to thwart this is for central banks to signal 'zero-tolerance' towards inflation build-up.
To do this, central banks should announce specific inflation targets and signal to the markets that they intend sticking to them. The less they waffle and juggle multiple objectives, the more successful they would be in stifling inflation.
Besides, given the fact that inflation has turned out to be a huge global problem, one could make a case for coordinated central bank action across economies. A possible model of coordination is for all major central banks to announce rigid inflation targets and keep tightening monetary policy until this target is met.
Second, the current financial crisis has shown us very clearly how inter-linkages between markets and geographies have made the global financial environment much more complex than we had imagined. This raises a question: should policymakers strive actively to reduce the degree of uncertainty or should they compound it?
I would argue that the policy environment should make things a little easier for financial markets and reduce the uncertainty in policy response. One way to reduce uncertainty in monetary policy is for central banks to stick to the thing they do best -- fight inflation and announce a quantitative target.
Thus, instead of trying to guess which of its multiple objectives is a central bank target at any given juncture, financial markets will focus on managing other risks and uncertainties. This is exactly the argument that the Raghuram Rajan committee on financial reforms makes in recommending a fixed inflation target for the RBI.
Does a move to a strict inflation targeting regime mean compromise on growth? There is ample empirical evidence that a necessary condition for sustained growth is low stable inflation. By switching to inflation targeting, central banks are likely to help growth, not impede it.
The author is chief economist, HDFC Bank. The views here are personal