Sunday, July 12, 2009

political pressure and monetary policy

while the fed is partially insulated from political pressure by its structure, it's not totally insulated. presidents place enormous pressure on the fed to use expansionary monetary policy (especially during an election year) and blame the fed for any recession. when interest rates rise, the fed takes the pressure, and if any members of the board of governors are politically aligned with the president, they find it difficult to persist in contractionary policy when the economy is in a recession.
one way central banks have tried to avoid that political pressure is through inflation targeting, where they set an inflation target they are required to meet. this means that their reaction to events is prescribed before the event, and the central banks can blame the inflation targeting rule they have to follow, rather than taking the blame themselves. the hope is that setting the target will add credibility to the policy and convince people that inflation will not occur, thereby reducing inflationary expectations and inflationary pressures. the problem is that if the policy is not believed, or if the wrong inflation target is chosen, the existence of the target can either limit the central bank's response or force the central banks to abandon their target, which can reduce rather than enhance credibility.

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