INFLATION TARGETING IN PRACTICE: FURTHER EVIDENCE

I. INTRODUCTION Since the early 1990s, a monetary policy strategy known as "inflation targeting" has been formally adopted by a number of industrialized countries. Under this approach, a monetary authority officially announces an inflation target level or target range, which generally is consistent with low or zero inflation, to be achieved within a specified time frame.(1) Both conceptual and practical issues of inflation targeting have received considerable attention in the literature. This paper focuses on the latter issue by drawing lessons from the experiences of three representative countries - New Zealand, Canada, and the U.K. - which have recently been studied by Ammer and Freeman (1995), McCallum (1996), Dueker and Fischer (1996), and Mishkin and Posen (1997). At a superficial level, recent inflation rates of 2% or less per annum across those three inflation-targeting countries lend credence to the new policy rule in operation. Moreover, in light of vector autoregression (VAR) simulations, most of the existing studies reveal substantial effect of inflation targeting on economic performance. Dueker and Fischer (1996), however, argue that conclusions based solely on unilateral evidence can be misguided, given that many other countries have also shared parallel disinflationary experiences even without employing any formal targeting framework. Their argument stems from the difficulty of disentangling effects due to inflation targeting from those due to other nonpolicy factors, such as a global absence of inflationary pressures attributable to recent falls in oil prices. This distinction is particularly crucial for the three small open economies. This paper attempts to provide further insights into the above unresolved issue. In contrast to existing cross-country case studies, this study involves a two-step approach that can offer more direct inferences on the performance of inflation-targeting countries relative to some non-inflation-targeting counterparts. The empirical work begins with employing the methodology of Vahid and Engle (1993), which helps remove stochastic trend and cyclical components in observed data that the three targeting countries have in common with some nontargeting neighbors. Subsequently, inflation-targeting regimes are evaluated by applying VAR simulations to the filtered country-specific data. In line with the country-pairing strategy employed earlier by Dueker and Fischer (1996), this study adopts a bilateral framework by pairing Canada with the U.S.; the U.K. with Germany; and New Zealand with Australia. The selection of the first two pairs is consistent with Engle and Kozicki (1993), who find evidence of common trends in their output series among those of the G-7 countries. Another reason for choosing the U.S. and Germany is their different official policy rules, which focus on targeting money growth or interest rates instead of inflation. Australia has followed the example of New Zealand by instituting an official target since mid- 1993. The Reserve Bank of Australia, however, has not announced any specific targeting time frame like those well defined by its New Zealand counterpart. Due to its late (official) entry into the targeting regime relative to New Zealand, inferences can be drawn at least through 1993. Juxtaposed against the observed data series, the country-specific time series clearly reveal that a great deal of unilateral evidence on regime-shift effects is in fact an artifact of cross-country comovements that are consequently removed. VAR simulations conditional on the country-specific data further confirm that the new monetary regimes have not been instrumental in reducing inflation beyond the levels already experienced in some nontargeting countries. This paper proceeds as follows. The next section offers an overview of the historical background, and presents VAR simulation results based on observed data. Section III discusses the bilateral data decomposition results. …