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Choice of Monetary policy regime in US (Inflation targeting ):

In the intellectual world a new theory called the Chaos Theory recognizes that the real world is unpredictable and is rarely controlled. It suggests that systems naturally get more complex; as these systems become more complex they become more volatile and must expend more energy to maintain that complexity. As they expend more energy, they seek more structure to maintain stability. This trend continues until the system splits, combines with another complex system or falls apart entirely. Sounds familiar? This trend is exactly what we are seeing in today's globalized World.
Choice of Monetary policy regime in US (Inflation targeting )

The fundamental ramification in the world economy brought about by globalization is definitely beyond anybody’s comprehensive understanding. As the world economy integrates it has become complex and volatile with each country behaving very much like a price taking firm in a perfectly competitive market incapable of controlling the world economy. Given the distortion in the world demand caused by the undervalued Yuan, the ever growing US current account deficit along with the falling US Dollar and the soaring Oil prices, the world economic system is falling apart seeking more structure to maintain stability. Unless there is coordinated effort at the international level especially between China and US there is very little that a country like India can do except be prepared for the uncertain.

In the midst of all these comes the retirement of Alan Greenspan in next January after serving for five consecutive terms as the chairman of Federal Reserve. Therefore Central bankers in US are considering the optimal monetary policy regime to maintain the credibility that they have achieved under the Chairmanship of Alan Greenspan. Whether to continue with the more ‘broad based approach’ in the conduct of monetary policy or to opt for ‘inflation targeting’, a trend which has become very popular among central bankers since the nineties.

Central bankers all over the world are not exactly known for clarity in their language and therefore proponents of inflation targeting argue that it promotes transparency and accountability in the operations of the Central Banks. As the rational expectations school in macroeconomics holds that no policy can be successful over a period by ‘fooling’ the economic agents direct inflation targeting has gained momentum among the bankers around the world.

However in view of the growing complexities in macroeconomic management task Central Banks needs to perform and the very important the role dollar plays internationally, inflation targeting would reduce the Fed's overall accountability by allowing it to avoid other responsibility internally and externally. While low inflation is one thing the Federal Reserve needs to control in the long, the Fed has reduced inflation steadily in the past 20 even without explicit policy.

Besides, with the ambiguity in the definition of inflation and absence of broad price index that can capture the overall rate of increase in prices including share prices, asset prices etc, inflation targeting would be too rigid and prevent the sort of flexible-risk-management approach to monetary policy followed under Greenspan. So the whole question of maintaining credibility and stability depends to a lesser degree on the policy regime and more on the future chairman. The Federal Reserve should continue to pursue multiple objectives of monetary policy, viz., a) maximum employment, b) stable prices, and c) moderate long-term interest rates while at the same time reinvigorating the its role as the world central bank in maintaining stability around the world.

By - Prasoon S Majumdar

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