I n t h I s c h a p t e r y o u w I l L

B r a z i l t o U s e I n f l a t i o n D a t a f o r
M a n a g i n g I n t e r e s t R a t e s
B
Y
P
ETER
F
RITSCH
R
IO DE
J
ANEIRO
—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.”
S
OURCE
:
The Wall Street Journal,
May 22, 1999,
p. A8.
I N T H E N E W S
Inflation Targeting

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C H A P T E R 3 4
F I V E D E B AT E S O V E R M A C R O E C O N O M I C P O L I C Y
7 9 7
October of that year Volcker moved to contract monetary policy to combat the
high rate of inflation that he had inherited from his predecessor. The predictable
result of Volcker’s decision was a recession, and the predictable result of the reces-
sion was a decline in Carter’s popularity. Rather than using monetary policy to
help the president who had appointed him, Volcker helped to ensure Carter’s de-
feat by Ronald Reagan in the November 1980 election.
The practical importance of time inconsistency is also far from clear. Although
most people are skeptical of central-bank announcements, central bankers can
achieve credibility over time by backing up their words with actions. In the 1990s,
the Fed achieved and maintained a low rate of inflation, despite the ever present
temptation to take advantage of the short-run tradeoff between inflation and un-
employment. This experience shows that low inflation does not require that the
Fed be committed to a policy rule.
Any attempt to replace discretion with a rule must confront the difficult task
of specifying a precise rule. Despite much research examining the costs and bene-
fits of alternative rules, economists have not reached a consensus about what a
good rule would be. Until there is a consensus, society has little choice but to give
central bankers discretion to conduct monetary policy as they see fit.
Q U I C K Q U I Z :
Give an example of a monetary policy rule. Why might
your rule be better than discretionary policy? Why might it be worse?
S H O U L D T H E C E N T R A L B A N K
A I M F O R Z E R O I N F L AT I O N ?
One of the