The U.S. disinflation experience in the early 1980s was the prime example of this. Known memorably as the Volcker disinflation, the Federal Reserve took about four years to bring down inflation, but at a cost of the 1981-2 recession which was the most severe in the post-World War II period. Of course, one could argue that monetary policy is ineffective against supply shocks and therefore raising the interest rate would only further hurt the economy. It is true that monetary policy is a demand management tool. It is true that the best remedy to tackle any supply shock should be one from the supply-side policy that mitigates its impact on production costs and the economy’s potential output. However, most supply-side policies take time. For example, it takes many years to improve the logistic system, education and skill attainment of the labor force, and institutional quality. 2  BIS Review 98/2008  On the other hand, alleviation measures such as promoting the use of alternative energy has had a limited impact on inflation. In the short run therefore, what is left as a clear option is to adjust the demand accordingly to ensure stability in the immediate future as well as the medium term. After all, it is also true that inflation is a monetary phenomenon and should be corrected by monetary policy. To make my point clearer, let me compare the current situation with the cake eating analogy. Suppose that you gain happiness from eating cakes. I guess we all do.
This is why modern central banks pay so much attention to ensure that inflation expectations do not run away. In general, how well a central bank can anchor the public’s inflation expectations will depend on the extent in which the public perceived the central bank’s seriousness in fighting inflation. Such credibility hinges critically on the central banks’ actions and what the public expect it to do. Words like “behind the curve” are often used to describe central banks that move too slowly to curb public’s inflation expectations. Central bank, unlike the government which has a fixed term, has a greater incentive to care for economic stability. While the government tends to be more myopic in their policies, central bank is mandated to optimize the benefits across horizon. History has taught us that  BIS Review 98/2008  3  a popular central bank is not always the most credible central bank. A pro-growth central bank is prone to inflationary bias which undermines its credibility in fighting inflation. Disinflation would then become more costly. Inflation targeting is one framework to discipline the central bank by paying attention to price stability. It has been working very well for us and for many other countries in the world that have adopted the regime. But the challenge today is to find the right sacrifice ratio between economic growth and inflation. In addition, the central bank must ensure that inflation expectation is under control and the adherence of inflation targeting framework can go a long way to ensure this.