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Abstract:
Inflation targeting (IT)--a policy framework that directly targets an explicit
inflation goal--has gained widespread attention recently as it has been adopted
by several OECD countries. There is a growing body of literature on the
ultimate long-term benefits of price stability and on theoretical issues related
to inflation targeting. But the short duration of this practice has limited
the number of works that empirically analyze the performance of IT regimes.
This paper examines the British inflation targeting experience since 1993 by
focusing on the out-of-sample forecast performance of models fitted to the
1980s. The model over-predicts actual short-term and long-term interest rates,
while its inflation forecast is on tract for the recent period. This implies
that it took less monetary tightening to obtain a favorable inflation outcome.
Identical exercises were repeated for France and the US, countries that have
not adopted IT but have experienced low inflation in the recent period. The
results for these countries show that recent low inflation has not been unusual
when compared to forecasts from the models designed to fit the second half of
the 1980s. That is, given the level of inflation, the degree of actual
monetary policy tightness (measured in terms of short-term interest rate) is
about what the model expects. Findings of this paper could be explained by
enhanced credibility of the UK monetary policy since the adoption of IT.
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