Countries where the central bank uses an inflation targeting framework for monetary policy are more resilient to the contractionary and inflationary effects of natural disasters. That is the central conclusion of research by Marcel Fratzscher, Christoph Grosse Steffen and Malte Rieth, to be presented at the Royal Economic Society''s annual conference at the University of Sussex in Brighton in March 2018.
Their study of 79 countries over the period 1970-2015 finds that economies under inflation targeting perform significantly better than non-inflation targeting countries. While GDP drops immediately under both regimes, the initial decline is smaller under inflation targeting and the subsequent recovery is stronger and faster.
Four years after the shock, output is about two percentage points higher and consumer prices roughly 6% lower than under alternative regimes. Moreover, inflation targeters are more successful in stabilising both output growth and inflation.
The researchers conclude that it is not the fact that a central bank formally adopts inflation targeting that allows superior performance. Instead, it is the track record and the ensuing credibility of an inflation targeting central bank that allows it as well as the fiscal authorities to respond differently and more successfully.
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To what extent can the monetary regime facilitate the absorption of large adverse shocks? Inflation targeting has become a dominant framework for monetary policy over the last two decades. But the costs of ''cleaning up'' after the global financial crisis have dramatically changed the perception of inflation targeting, since it may disregard the build-up of financial imbalances through its narrow focus on consumer prices.
As a result, scholars and policy-makers have called for a refinement of the inflation targeting framework by allowing for more flexibility. At the same time, there is only little we know empirically about the role of inflation targeting during crisis times and the trade-offs involved when allowing for more flexibility in inflation targeting frameworks.
The new analysis makes use of the exogenous occurrence of natural disasters in order to answer the question. Natural disasters have a detrimental impact on the macroeconomy through the destruction of the physical capital stock and durable consumption goods such as housing and cars.
Disasters can be considered exogenous to the choice of the monetary regime because they are largely unpredictable and not caused by economic conditions. A natural disaster is contractionary and inflationary on impact, followed by a short-lived boom in consumption and investment, and a longer lasting increase in inflation.
The empirical analysis shows that economies under inflation targeting perform significantly better than non-inflation targeting countries. While GDP drops immediately under both regimes, the initial decline is smaller under inflation targeting and the subsequent recovery is stronger and faster.
Four years after the shock, output is about two percentage points higher and consumer prices roughly 6% lower than under alternative regimes. Moreover, inflation targeters are more successful in stabilising both output growth and inflation.
Through which mechanisms does inflation targeting affect the adjustment process to large shocks? Targeters rely on a different monetary-fiscal policy mix. Targeting central banks tighten monetary policy more or loosen it less following the adverse shock to stabilise inflation, while fiscal policy is accommodating.
These policy responses lower the shock-induced volatility of changes in output and inflation relative to non-targeters. Lower volatility, in turn, is associated with smaller countercyclical private credit risk and lower term premia. The stability of consumer prices translates into a more stable real exchange rate.
Finally, the better macroeconomic performance is only realised by hard targeters that mostly comply with their inflation targets. There is only limited evidence that countries that have introduced inflation targeting, but deviate from their target for a prolonged period of time, reap the fruits of an enhanced conditional macroeconomic performance.
This difference suggests that it is not the fact that a central bank formally adopts inflation targeting that allows superior performance. Instead, it is the track record and the ensuing credibility of an inflation targeting central bank that allows it as well as the fiscal authorities to respond differently and more successfully.
These results are important along two dimensions. First, the better adjustment to large natural disasters of inflation targeting countries suggests that inflation targeting has been more of a saviour during the global financial crisis than thought. Even if the endogeneity problem makes it hard to study the role of inflation targeting during that period, the results obtained through the analysis of exogenous natural disasters might well be transferable to the case of the crisis.
Second, when reforming the present inflation targeting frameworks toward more flexibility, it should be considered that allowing for prolonged deviations from the target range can come at a cost in terms of lower shock resilience.
Inflation Targeting and Large Shocks – Marcel Fratzscher, Christoph Grosse Steffen and Malte Rieth
