Do Inflation Targets Redefine Central Bank Inflation Preferences? Results from an Indicator Model

Abstract

This paper examines whether inflation targets have been instrumental in reducing the policy-implied, short-term trend rate of inflation, which is defined as the baseline inflation rate. To investigate whether announced targets have generated distinct benefits in terms of reductions in the baseline inflation rate to date, the authors compare the baseline inflation rates in three inflation-targeting countries with those in neighboring non-inflation-targeting countries. The study matches New Zealand with Australia; Canada with the United States; and the United Kingdom with Germany.

The comparative analysis stemming from an indicator model using a Markov-switching process suggests that inflation targets have brought about a change in inflation preferences in the 1990s. This statement needs to be qualified however, because the inflation-targeting countries generally followed a non-inflation-targeting neighbor in reducing their baseline inflation rates. The United States and Germany shifted to a low baseline path prior to similar shifts by their inflation-targeting neighbors. Given that the neighboring countries moved first and appear to have settled on a lower baseline inflation rate, it is difficult to determine how instrumental the targets were in bringing about the shift in preferences.

The authors would like to thank Clive Briault, Clemens Kool, Manfred Neumann and Mathias Zurlinden for helpful comments. Rita Meier provided valuable assistance in preparing this manuscript.