What this means is that if members of the public do not believe in the central bank’s ability to control inflation, a rise in prices could trigger public expectations that prices will rise even more in the future. Businesses will soon raise prices of goods, and workers, in facing higher prices, will in turn demand for higher wages, leading to a vicious inflationary cycle. Inflationary expectations, if unhinged, would eventually become a self-fulfilling prophecy. As such, the interest rate increase reflects the central bank’s strong commitment to control inflation. A central bank that is seen as having a strong commitment and is credible in its actions to fighting inflation would therefore have a higher probability of success in anchoring inflation expectations. This is essentially what we will find in every textbook on monetary policy. In reality, however, there is more to inflation expectations than meets the eye. A case in point is Malaysia’s inflation experience in 2008. At that time, we had the firm conviction that the spike in inflation and inflation expectations during the period would be temporary, as the prospect of weakening demand would dampen price increases in the future. Most importantly, we also saw the sharp spike in commodity prices and increasing risks from the US financial market which posed significant downside risk to future growth. As events began to unfold, this conjecture turned out to be the baseline case.
The company then advised their customers to remove heavy objects attached to their car keys, such as bulky keychains, rather than fixing the root of the problem itself. This story is not strange. It happens elsewhere as well. In the world of central banking, serious risks can similarly arise from groupthink. There are many rules governing policymaking that policymakers tend to follow rigidly, despite its waning effectiveness. This increases the risks of being blindsided and promotes a culture that is resistant to change. An example of this in central banking is the ‘inflation-targeting framework’ which was considered the international best practice in monetary policy framework for many years before the Great Financial Crisis. My remarks are not a critique of the framework but rather, to highlight that there are other approaches as well. The premise behind the framework is very simple. It is also elegant. If the inflation trend deviates beyond a central bank’s expected target, typically around 2%, the central bank should use its policy tools, namely the interest rate, to bring inflation back to target. Inflation targeting enables monetary policy to focus on domestic variables and respond to external stimulus that impact domestic price stability. Since it was first adopted in 1989, it was seen as a simpler and more transparent policy framework because it allowed the public to easily understand and observe the central bank’s motive, which is ultimately low and stable inflation.