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Inflation targeting performance following financial crises 2008.
Abstract:
Following Filho (2010) and applying Ball's (2010) method, I evaluate the performance of inflation targeting regime under both advanced and non-advanced countries in comparison with non-inflation targeting regime following the onset crises 2008. I estimate the effect of inflation targeting on the post crises 2008 change in the output growth and I find that following financial crises 2008 inflation targeting does matter for advanced countries. This result is fairly robust to the several control variables including (i) the growth rate before the crises 2008 and (ii) policy rate cut at the onset crises 2008. Moreover, I could not find robust evidence that following financial crises 2008 inflation targeting does matter for non-advanced countries.

Keywords: Inflation Targeting, Monetary Policy, Credibility

Article Type:
Report
Subject:
Inflation (Finance) (Forecasts and trends)
Inflation (Finance) (United States)
Economic growth (Forecasts and trends)
Author:
Astrayuda, Indra
Pub Date:
11/01/2012
Publication:
Name: Journal of International Business and Economics Publisher: International Academy of Business and Economics Audience: Academic Format: Magazine/Journal Subject: Business, international; Computers Copyright: COPYRIGHT 2012 International Academy of Business and Economics ISSN: 1544-8037
Issue:
Date: Nov, 2012 Source Volume: 12 Source Issue: 4
Topic:
Temporal Scope: 2008 AD Event Code: 010 Forecasts, trends, outlooks Computer Subject: Market trend/market analysis
Geographic:
Geographic Scope: United States Geographic Code: 1USA United States
Accession Number:
312172994
Full Text:
1. INTRODUCTION

Several recent studies suggest that inflation targeting countries performed better than non-inflation targeting countries did during the financial crises 2008. Filho (2010) finds the benefit of inflation targeting, in particular there is a positive effect of inflation targeting framework on the post-crises 2008 change in GDP growth rate. Walsh (2010) finds that both inflation targeting and non-inflation targeting countries experienced a decrease in the real GDP growth rate during period 2008-2010 (relative to the period 1995-2007), but inflation targeting countries have done somewhat better. Roger (2010) based on Consensus Forecast in January suggests that emerging-inflation targeting countries are less adversely affected by current financial crises than emerging- non inflation targeting countries. However, there is still no clear evidence that during financial crises 2008, the performance of inflation targeting is different between inflation targeting under advanced countries group and non-advanced countries group. In particular, there is still no clear consensus whether during financial crises 2008, the performance of inflation targeting is better for both advanced and non-advanced countries group.

In this paper, I evaluate the performance of inflation targeting regime under both advanced and non-advanced countries in comparison with non-inflation targeting regime following the onset crises 2008. I apply the Ball's method (2010) in estimating the effect of inflation targeting on the post crises change in the output growth. I calculate the post crises change in the output growth ("growth acceleration" as defined by Filho (2010)) as the difference between annual growth rate 2008H1-2010H1 and annual growth rate 2003H1-2008H1. The sample for this empirical study consists of 51 countries; the same sets used by Filho (2010). For the purpose of robust analysis, I apply wider control variables, including (i) the growth rate before the crises 2008 and (ii) policy rate cut at the onset crises 2008. Thus, the contribution of the paper will be in the two folds: (i) applying Ball's method (2010) in estimating the performance of inflation targeting during financial crises 2008 for both advanced countries and non-advanced countries group; and (ii) applying wider control variables. This paper will shed another light about the performance of inflation targeting following financial crises 2008.

I find that inflation targeting does matter (for the output growth) for advanced countries. The result is robust to the several control variables including (i) the growth rate before the crises 2008 and (ii) policy rate cut at the onset crises 2008. Moreover, I could not find robust evidence that following financial crises 2008 inflation targeting does matter (for the output growth) for non-advanced countries.

In addition, I evaluate the two possible channels of the advantage (in term of output growth) of having inflation targeting as the monetary framework. The first channel is that inflation targeting countries tend to react more (by having more policy rate cut) at the onset crises 2008 and more aggressive policy rate cut is likely associated with less economic downturn due the crises. I call the first channel as the indirect effect. The second channel is the direct effect through having inflation targeting as the monetary policy framework. I find that the effect by having inflation targeting as the monetary policy framework is not significant through the first channel (indirect effect through policy rate change), but the direct effect by having inflation targeting as monetary policy framework (through the second channel) is significant. In other words, it confirms the result I found: inflation targeting does matter (for the output growth) for advanced countries.

As one might argue that higher credibility might be the key different between inflation targeting and non-inflation targeting, I conduct empirical test on credibility level and anchored expected inflation. Based on the result, I could not find robust evidence that for advanced countries group, inflation targeting countries have higher credibility than non-inflation targeting countries have. Moreover, I also could not find robust evidence that expected inflation is well and better anchored under inflation targeting framework than non-inflation targeting framework.

The rest of this paper contains five sections. Section 2 provides the estimation method for the effect of inflation targeting on the post crises change in the output growth and Section 3 presents the results. Section 4 discusses the central bank credibility level for advanced economies. Section 5 concludes.

2. METHOD

I estimate the effect of inflation targeting on the post crises change in the output growth under following specification: [Y.sub.2]- [Y.sub.1] = [alpha] + [[beta].sub.2][D.sub.2] + [[beta].sub.3][D.sub.3] + [[beta].sub.4][D.sub.4] + [[beta].sub.6][Y.sub.1] + [[beta].sub.7]X + [epsilon]

(1), where

[Y.sub.1] = annual growth rate between 2003H1-2008H1

[Y.sub.2] = annual growth rate between 2008H1-2010H1

[Y.sub.2]-[Y.sub.1] = Y = growth acceleration as defined by Filho (2010)

[D.sub.2] = ditadv variable, equals to 1 if inflation targeting and advanced countries; and 0 otherwise

[D.sub.3=] ditnadv variable, equals to 1 if inflation targeting and non-advanced countries; and 0 otherwise

[D.sub.4] = dummy adv variable, equals to 1 if advanced countries; and 0 otherwise

X = control variable

Adapting from Ball (2010), I incorporate the growth rate before the crises (Y1) on the right hand side of estimation model to control initial level of performance. As discussed in Ball (2010), the introducing of initial level of performance will eliminate bias in the pure different-in-different estimates.

3. ESTIMATION

3.1. Baseline Scenario

In this section, I do estimating based on the same set of countries (51 countries) used by Filho (2010). First, I estimate based on Filho (2010) specification and second, I estimate based on Filho (2010) modified by the introduction of the growth rate before the crises (Y1) on the right hand side of estimation model to control initial level of performance. As shown in the Table-1, based on second specification (controlling the growth rate before the crises), the test shows that the coefficient for ditadv (inflation targeting and advanced countries) is positive and significant, but the coefficient for ditnadv (inflation targeting and non-advanced countries) is not significant. That is, inflation targeting does matter for advanced countries.

Thus based on these results, the evidence that inflation targeting does matter (for the output growth) for advanced countries is robust to the model specification with initial level control variable. Moreover, as the coefficient for ditnadv (inflation targeting and non-advanced countries) is significant under first specification (Filho's specification), but less (or not) significant under second specification, one can argue that inflation targeting is less matter under second specification. Hence, it seems that the evidence that inflation targeting does matter for non-advanced countries is not fairly robust and it should be taken cautiously.

For the purpose of robust analysis, I estimate the model specification (i) by adding USA in the sample (the sample = 52 countries now); (ii) with other control variables used in the Filho (2010); and (iii) by merging all ECB members in the sample into one Euro. I find similar results: the coefficient for ditadv (inflation targeting and advanced countries) is positive and significant for most cases, and the coefficient for ditnadv (inflation targeting and non-advanced countries) is not significant for several cases. That is, the evidence that inflation targeting does matter (for the output growth) for advanced countries is still fairly robust.

3.2. Baseline Scenario with Policy Rate Change as Control Variable

From discussion in the previous section, inflation targeting does matter (for the output growth) for advanced countries. The advantage and effect having inflation targeting as the monetary policy framework can be traced into two possible channels:

(i) Indirect effect through policy rate change

Inflation targeting countries tend to react more (by having more policy rate cut) at the onset crises 2008 and more aggressive policy rate cut is likely associated with less economic downturn due the crises. Indeed, following the onset financial crises 2008, many central banks reduced the policy rate aggressively as the response to the likely economic downturn due the crises.

(ii) Direct effect through having inflation targeting as the monetary policy framework. In this section, I re-estimate the baseline scenario by adding the policy rate change as control variable to investigate the two possible channels of the advantage having inflation targeting as the monetary policy framework. I define new variable ichange2= average the policy rate 2008Q4-average policy rate 2008Q3.

The result shows that the coefficient of ichange2 is negative and but not significant (see Table-1). This suggests that having policy rate cut has no significant effect on the output growth. The effect by having inflation targeting as the monetary policy framework is not significant through the first channel (indirect effect through policy rate change). Moreover, the coefficient for ditadv is positive and significant, but the coefficient for ditnadv is not significant. Thus, the direct effect by having inflation targeting as monetary policy framework (through the second channel) is significant. In other words, it confirms the result I found in the previous section: inflation targeting does matter (for the output growth) for advanced countries.

Above result is fairly robust to following model specification: (i) by applying different definition of ichange; (ii) by adding USA in the sample (the sample = 52 countries now); (iii) by merging all ECB members in the sample into one Euro and adding USA in the sample; (iv) with other control variables used in the Filho (2010). Thus based on these results, the evidence that inflation targeting does matter (for the output growth) for advanced countries is still fairly robust. Moreover, similar with the argument discussed in the previous section, I could not find the robust evidence that inflation targeting does matter for non-advanced countries.

4. CENTRAL BANK CREDIBILITY AND ANCHORED EXPECTED INFLATION: ADVANCED COUNTRIES GROUP.

As discussed in the previous section, I found that inflation targeting does matter for output growth for advanced countries. One might argue that this is not surprising result as the inflation targeting-advanced countries have gained better credibility than non-inflation targeting-advanced countries have. Indeed, one might argue the benefits of higher credibility:

(i) Credibility helps central bank facing deflationary risk (Bini Smaghi (2009), Carney (2009), Filho (2010), Gertler (2009)). With the well anchored expected inflation, the credibility helps the central bank keeping inflation around the target level, thus helps them avoiding the liquidity trap in times of disinflationary pressure during financial crises 2008.

(ii) Credibility gives central bank the flexibility to deviate from short term target to alleviate the financial and economic downturn while keeping the inflation within the target (explicitly and implicitly) in the long term (Carney (2012), Steven (2009), Mishkin (2008)).

(iii)Credibility helps central bank keeping inflation low and stable. This conducive environment might allow businesses and households to take a longer view with respect to their planning, which has led to a better allocation of economic and financial resources.

Thus on top of this, one might argue that high degree credibility is the essential characteristic of advanced and inflation targeting countries. The higher credibility might be the key different between inflation targeting and non-inflation targeting. Hence it might help explaining the better performance of inflation targeting-advanced countries than others.

In this section, I estimate the central bank's credibility and compare the credibility level between inflation targeting--advanced countries and non-inflation targeting--advanced countries. Moreover, under high degree of central bank credibility environment, people are convinced that central bank monetary policy would be credible in achieving the inflation target. Thus the expected inflation would be anchored to the inflation target leading to the actual inflation being anchored to inflation target as well. Hence, in addition to the credibility level test, I also conduct a test whether the expected inflation is well and better anchored under inflation targeting framework than non-inflation targeting framework.

4.1. Central Bank Credibility

Blinder (2000) defines that "a central bank is credible if people believe it will do what it says". Within this context, an inflation targeting central bank is credible if people believe that the central bank will implement the policy that consistent with their commitment to achieve the explicitly stated inflation target. Thus the inflation targeting central bank credibility can be built through the (i) track record showing the policy action consistent their commitment and (ii) history of keeping inflation at the low level and stable.

Thus, the simplest way to measure central bank credibility is by tracking the deviation of actual inflation from the target. In this paper, I measure credibility as:

credibl = average [100/exp (actual inflation - target inflation)] (2)

The time period analysis for baseline scenario is 2000m1-2008m12. In addition, I set 2000 as starting period of analysis by considering that (i) as in the late 1990s and the early 2000s, most inflation targeting- advanced countries in sample has implemented the inflation targeting framework and (ii) the 2000 is the starting year after the formation of ECB.

I estimate the central bank credibility for the advanced countries group (30 countries) and compare the credibility level between inflation targeting (10 countries) and non-inflation targeting countries (20 countries). For non-inflation targeting countries group, I assume the inflation target is 2%. Based on the result, I find that for the advanced countries group, the average credibility level for inflation targeting countries (90.06) is higher than the average value for non-inflation targeting (86.09). However further regression analysis the credibility on dummy IT shows the coefficient for dummy IT is not significant; thus the difference in credibility level between inflation targeting is not significant. Thus it seems that for the advanced countries group, I could not find the robust evidence that the inflation targeting countries have better credibility than non-inflation targeting countries have.

In order to test the robustness of the result, I estimate the credibility under following scenarios : (i) by excluding Hong Kong from the sample; (ii) by applying different inflation target assumption for non-inflation targeting countries (for example Japan 1%, USA 2.5% and ECB members 1%); and (iii) by applying different measurement of credibility. Under scenario (iii), I measure credibility as:

credib2 = average [1 - abs (actual inflation - expected inflation)/expected inflation] * 100; and credib3 = average [1 - abs (actual inflation - expected inflation)] * 100;

Under above scenarios, I find similar result: the inflation targeting and non-inflation targeting group have no different in credibility level. That is, I still could not find the robust evidence that the inflation targeting countries have better credibility than non-inflation targeting countries have.

4.2. Anchored Expected Inflation

In this section, I test whether the expected inflation is anchored around the inflation target level. Consistent with previous section, I assume the inflation target level (explicitly and implicitly) is 2% for all advanced counties in my sample. Adapting from Ball (2011), I estimate following specification for advanced countries group:

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (3), where

E([[product].sub.t]) = expected inflation (taken from Consensus Forecast)

[[product].sub.t-i] = actual inflation at t-1

I obtain expected inflation (next year estimation) from Consensus Forecast. Due to limited availability of Consensus Forecast, the sample for this analysis consists of 21 countries (Austria, Belgium, Denmark, Finland, Greece, Ireland, Luxembourg and Portugal are excluded). As the Consensus Forecast is available since 2004, I set the period of analysis: 2004m1-2008m12.

For each 21 countries, I estimate model (3) and obtain the coefficient and standard error estimates for O. I am interested to the weighted average of coefficient estimates for two groups (i) inflation targeting and (ii) non inflation targeting. The weight for the coefficient estimates is inversely related to the variance of coefficient estimates. By comparing the weighted average for both two groups, I conduct the test whether the expected inflation is better anchored under inflation targeting or under non inflation targeting countries group. Table 2 summarizes the weighted average for each group.

The results show that under Scenario A (for both include and exclude Hong Kong from sample) the coefficient estimates for inflation targeting group is less than that for non-inflation targeting group. Moreover under Scenario B (exclude Hong Kong), the coefficient estimate for inflation targeting group is higher than that for non-inflation targeting group but the difference is not significant. These results suggest that the expected inflation for inflation targeting group is not better anchored than that for non-inflation targeting group. In other words, I could not find robust evidence that inflation targeting group is better anchored.

5. CONCLUSION

Following Filho (2010) and applying Ball's (2010) method, I evaluate the performance of inflation targeting regime under both advanced and non-advanced countries in comparison with non-inflation targeting regime following the onset crises 2008. I estimate the effect of inflation targeting on the post crises change in the output growth. I apply Filho's (2010) "growth acceleration" as the the post crises change in the output growth.

As discussed in previous section, I found that following financial crises 2008 inflation targeting does matter (for the output growth) for advanced countries. This result is fairly robust to the several control variables including (i) the growth rate before the crises 2008 and (ii) policy rate cut at the onset crises 2008. Hence, for advanced countries, inflation targeting seems to be a recommended monetary policy framework. Moreover, I could not find robust evidence that following financial crises 2008 inflation targeting does matter (for the output growth) for non-advanced countries.

As one might argue that higher credibility might be the key different between inflation targeting and non-inflation targeting, I conduct empirical test on credibility level and anchored expected inflation. Based on the result, I could not find robust evidence that for advanced countries group, inflation targeting countries have higher credibility than non-inflation targeting counties have. Moreover, I also could not find robust evidence that expected inflation is well and better anchored under inflation targeting framework than non-inflation targeting framework. Thus on top of this, it is still a puzzle why for advanced countries, the inflation targeting does matter. This is still an open and interesting venue of further research.

REFERENCES

Ball, Laurence. 2010. "The Performance of Alternative Monetary Regimes," NBER Working Paper 16124.

Bini-Smaghi, Lorenzo. 2009. "Inflation and Deflation Risks : How to recognize them? How to avoid them ?" Speech on XXI Villa Mondragone International Economic Seminar.

Blinder, A. S. "Central Bank Credibility: Why Do We Care? How Do We Build It?" The American Economic Review 90, 5 (December 2000): 1421-1431.

Carney, Mark. 2012. "A Monetary Policy Framework for All Seasons". Remarks to US Monetary Policy Forum, New York, 24 February 2012.

Carney, Mark. 2009. "Inflation Targeting in a global recession". Remarks to the Halifax Chamber of Commerce, Halifax, Nova Scotia, 27 January 2009.

De Carvalho Filho, Irineu. 2011. "28 Months Later: How Inflation Targeters Outperformed Their Peers in the Great Recession." MPRA Working Paper 29100.

De Carvalho Filho, Irineu. 2010. "Inflation Targeting and the Crisis: An Empirical Assessment." IMF Working Paper WP/10/45.

Getler, Mark 2010. "Inflation Targeting, the Financial Crises and Macroeconomics: an interview with Mark Gertler.", Reserve Bank of New Zealand : Bulletin, Vol. 73, No. 1, March 2010.

Mishkin, Frederic S. 2008. "Monetary Policy Flexibility, Risk Management, and Financial Disruptions". Speech at Federal Reserve Bank of New York, New York, 11 January 2008.

Roger, Scott. 2009. "Inflation Targeting at 20: Achievements and Challenges," IMF Working Paper 09/236.

Stevens, Gleen. Mishkin. 2008. "The Conduct of Monetary Policy in Crises and Recovery". Speech at the John Curtis Institute of Public Policy and the Financial Services Institute of Australasia Public Policy Breakfast Forum, Perth, 15 October 2009/.

Walsh, C.E. 2010. "The Future of Inflation Targeting," Manuscript, University of California, Santa Cruz.

AUTHOR PROFILE:

Indra Astrayuda earned his MA from Johns Hopkins University. He is currently PhD candidate at Johns Hopkins University, USA and working at Bank Indonesia, Indonesia.

Indra Astrayuda, Johns Hopkins University, USA and Bank Indonesia, Indonesia
Table-1 Estimation Result

               scenario1    scenario2    scenario3

VARIABLES      Y            Y            Y
ditadv         0.0180 *     0.0176 **    0.0173 **

               (0.010)      (0.007)      (0.007)
ditnadv        0.0265 **
                            0.024        0.024

               (0.011)      (0.016)      (0.017)
dummyadv
               0.015        0.010        0.009

               (0.010)      (0.016)      (0.020)
Y1                          -            - 0.116
                            0.109

                            (0.202)      (0.195)
ichange2                                 0.001
                                         (0.005)
Constant       -            -            -
               0.0680 ***   0.0595 ***   0.0588 ***

               (0.008)      (0.020)      (0.021)
Observations   51           51           51

R-squared      0.173        0.178        0.178

Scenario 1: Filho (2010)

Table-2 Weighted Average

             Scenario A            Scenario B

                   exc. Hong             exc. Hong
                   Kong                  Kong
IT
Coef     0.591     0.591       0.690     0.690
SE       (0.010)   (0.010)     (0.010)   (0.010)
Non IT
Coef     0.604     0.618       0.656     0.672
SE       (0.009)   (0.009)     (0.009)   (0.009)
ttest    -0.966    -2.007      2.527     1.338

Scenario A: I assume the anchored inflation level: 2%
Scenario B: I assume the individual inflation target as the anchored
inflation level. In addition the
"inflation target" for non-inflation targeting: 2%, except Japan
(1%), USA (2.5%) and ECB members (1.75%)
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