Inflation Targeting and Economic Performance

Sarah Mougamian

Historical Background

The mass of central banking systems in economically significant countries were first formed between 1870 and 1920. Their primary purpose at the time was to control (peg) the country’s currency exchange value by maintaining a legally-specified exchange rate with gold.  The gold standard fell out of use during the first World War and few countries were able to return to it at the war’s end due to the inflation and loss of national wealth incurred through financing the war.  Floating exchange rates gave central banks new freedom to manipulate the economy, but government needed to redefine their purpose.  This redefinition did not occur concisely, definitively, or in a timely  fashion.  Central banks fluctuated between policy of strict rules (such as the k-rule which Friedman advocated) and policy of complete discretion (which predominated during the 60’s and ultimately fell short of expectation).  The approach which is currently utilized by most central banks (albeit implicitly) is an approach Bernanke calls “constrained discretion.”  The tenets of constrained discretion are central bank commitment to low/stable inflation rates, and use of monetary policy to smooth cyclical fluctuation in resource utilization.

In 1990, New Zealand was the first of several developed economies to adopt an explicit inflation target as the primary objective of it’s central bank.  Many other banks followed suite declaring to the public an explicit inflation target, and the remainder of central banks implemented policy based on an implicit target.  The fundamental different between implicit and explicit targeters is the public announcement effect.  Inflation targeting works in two ways, first by dictating the policy decisions of central banks, and secondly by influencing (optimally moderating) public inflation expectation.  Explicit targeting was presumed to have a more significant impact on public expectation than implicit targeting because it communicated directly with the populace and made clear the central bank’s commitment to low/stable inflation rates.  However, the experiences of inflation targeting regimes (implicit and explicit)  is the only measure of the real impact of explicit vs. implicit targeting.

Investigation Question

Is there empirical evidence demonstrating that explicit inflation-rate targeting (as opposed to implicit inflation-rate targeting) effects better economic performance as measured by resulting inflation and economic growth rates?

Literature Review

During the 1990’s and early 200’s there was a strong research focus on investigating the real impact of explicit inflation targeting (IT).  Several researchers conducted quantitative analysis which sought to determine if explicit IT countries performed better than non-explicit (usually implicit) IT countries.  Researches employed a variety of models, but the most direct and relevant model was a simple regression model relating performance metrics (inflation-rate growth, GDP growth, and interest rates) to a binary variable representing use/no-use of explicit IT.  This model was constructed by Ball and Sheridan (2004) and controlled for varying inflation rate start points and regression to mean levels of inflation rate growth.

Conclusions

Researchers concluded (fairly unanimously) that explicit IT may increase rate of regression to mean inflation levels (for countries with high inflation initially), but are not empirically proven to improve inflation rate stabilization or (by extension) performance metrics of a given country.  They conclude that the public expectation effect of explicit targeters does not definitively  improve economic performance in comparison to non-explicit targeters.  Researchers were careful to point out that analysis did not conclude that explicit targeting has any negative effects on performance metrics, only that they do could not conclude a definite, statistically-significant positive effect.

However, researchers also proposed that explicit IT may be specifically beneficial during eras of exogenous economic shocks in which public expectation has a greater effect on a country’s economic path.  I propose replicating the Ball and Sheridan study using data that includes the 2008 recession era.  This may generate new understanding of the real impact of explicit IT.