The nation must congratulate the BB and support its vision towards evolving into an independent monetary policy authority.

Unfortunately, notwithstanding the prospects of long-term economic welfare at the expense of some short-term hardships, both the Daily Star editorial and the business community reacted unfavourably in haste. For example, Chamber of Commerce and Industries (CCI) President Nasir Hossain viewed it as a difficult to borrow policy which will affect business expansion and production. Isn't it precisely the reason the BB designed the policy? He argued that businesses have already imported the capital goods and now without sufficient working capital there will be unused idle capacity straining production.

Prices are precursors to everything that happens in a market economy. The information they provide forms the rational basis for individuals and firms to ensure that resources are allocated efficiently. Economists generally agree that low inflation is the basis for general economic prosperity and high inflation retards economic growth by distorting resource allocations.

Understanding the economic processes that generate inflation has been an important, yet elusive objective for macroeconomists and monetary policy authorities. The Phillips curve notion of a trade-off between unemployment and inflation (lower inflation is associated with higher unemployment and vice versa) provided an early theoretical framework, but in its original form failed to provide a reliable basis for forecasting and policy-making. One piece of the puzzle is the role of inflation expectations in the inflation generating process.

How inflationary expectations affect the economic welfare of the citizens need not be confined to the realm of economists and professionals. Public's understanding of the process is also helpful in devising and adjusting the policy stances.

Higher expected inflation feeds into itself and breeds a spectre that fuels further inflation. In an effort to beat tomorrow's price increases people rush to buy goods today to hoard them aggravating the already vicious price spirals and aggregate demand. Unless this price inertia is disrupted by immediate monetary and fiscal restraints coupled with increased supply of goods whose prices are increasing (e.g. rice, edible oil, lentil, sugar, salt etc), price instability will befall into a nightmare.

There is another channel by which higher expected inflation fuels inflation. Real interest rate = nominal interest rate minus the expected inflation rate. This equation implies that as expected inflation rate increases, the real interest rate decreases (assuming the nominal interest adjusts upward slowly). This decrease in real interest rate lowers the real cost of borrowing and thus stimulates businesses' borrowing for capital expenditure. This amplifies aggregate demand and consequently actual inflation.

Expected inflation is a menace in that it affects labour negotiations and consequently, wages, production costs, and actual inflation. Economic policies work not only through their direct effects, but also through their effects on expectations, including expectations of inflation. Thus, expectations of inflation play an important role in economic activities and policy making.

The current CPI inflation rate of over 7.8 percent with a real GDP growth of 6.8 percent given the recent successive crude oil price hikes may not seem alarming to some quarters. But people with fixed incomes are hurting because their purchasing power has decreased by 1 percent. With further upward adjustment of oil prices, the inflations rate is expected to slide up bringing more miseries to fixed income consumers due to further erosion of purchasing power.

Controlling money and credit growth to achieve the target output growth and price inflation is the goal of all central bankers. To implement such a policy requires advanced econometric models with trained economists capable of interpreting model's estimated parameters and predictions using new and revised data under evolving market conditions. In the absence of econometric expertise, the BB will have to rely on "guessing and missing" and in the process risk the possibility of throwing the economy into credit crunch, deep recession or into a run away inflation.

In order to manage its money and credit growth policy BB may have to deter adverse noises percolating from the following sources:

• Political pressures in an election year of borrowing and spending.
• Should not accommodate inflation induced increase in money demand. Money demand, which is not controllable by the BB, generally accompanies high inflation as people need more money to buy the same basket of consumption goods.
• A lot of money is loitering outside the banking system. During periods of high inflation these money slowly tiptoes into market places pulling prices of daily essentials higher.
• In periods of high inflation followed by rising interest rates, there is a potential for more loan default,
• The implausible effects on the financial market of the "black money whitening" episode?
• Supply shocks pervading out of uncertain oils prices, political strife, terrorists' violence, natural disasters etc.
• To achieve its policy goals, the BB may also review the following suggestions:
• The regional BB branch offices should be assigned with collecting price information on various products to construct BB's own CPI. This should then be compared with the CPI constructed by the Bangladesh Bureau of Statistics to fine tune the policy as needed.
• The BB should maintain a "Base Book" like that of the US Federal Reserve about changing business conditions across various regions of the country and then aggregate the data to fine tune its policy parameters, if warranted.
• Monitoring the money and credit growth on a weekly basis and adjust their growth rates as the CPI and other indicators are made available.
• To accommodate concerns about credit crunch, a selective credit rationing regime should be innovated allowing businesses to borrow enough working capital to support the capital investment already made. Credit should also be extended to other businesses facing the immediate need for replacement of worn out capital goods but not for expansion.
• At my seminar in the BB on March 9, 2005 on "Macro Econometrics of Survey Measures of Inflation Expectations," I argued that collecting inflationary expectations data based on random scientific survey of consumers similar to many industrialized countries would enable the BB to better understand the inflationary process for prudent policy making.

Politicians may not act in the best interest of the country's long-term economic outlook and goals because they have a vested interest to appease their constituents before the next election -- including manipulating interest rates to bring an elusive short-term prosperity at the expense of long-term stability. Given the power to choose, politicians will opt for monetary policies that are overly accommodative. Low interest rates are alluring to politicians because there are more borrowing voters than lenders. While many politicians do act in their countries' long-term interests, there is no dearth of examples of reckless fiscal behaviour in our world.

The author is Professor of Economics, Eastern Michigan University.