Does Institutional Change Really Matter? Inflation Targets, Central Bank Reform and Interest Rate Policy in the OECD Countries

Abstract

We estimate forward–looking interest rate reaction functions for the G3 and some inflation targeters. Shifts in the conduct of monetary policy are detected for the USA and Japan. In contrast with the existing literature, we show that these countries only shifted to policies consistent with an implicit inflation–targeting regime in the 1990s. Inflation targets and central bank reforms in Sweden, the UK, Canada and New Zealand only led in some cases to changes in policy responses, and changes in policy pre–date the introduction of targets. We challenge the one–model–fits–all approach towards monetary policy that permeates much of the current literature.

Inflation Targeting and Monetary Policy Activism

“…This enables us to see more precisely the timing of changes in the activism in-dicator, which may not necessarily be captured by the split sample estimation used in the existing literature. We find that, somewhat in line with the rolling regression results of Muscatelli et al (2002), activism appears to have increased before (not after) the adoption of the inflation-targeting policy framework. Moreover, with the benefit of posttarget data, we also find that the activism indicator declined recently, although the extent of decline in the activism indicators varies across countries.…”

“…This point is highlighted by Figure 2, where the corresponding activism indicators in Figure 1 are redrawn so that zero may correspond to the timing of the adoption of 5 The responsibility of the monetary policy decision was passed to the European Central Bank from 1999Q1. 6 The low level of activism in Japan is in line with Muscatelli et al (2002), who estimate it to be 0.72 using data from 1970Q2 to 1999Q2. We suspect this may be related to the Bank of Japan's reliance on quantitative measures in the 1970s and 1980s including "window guidance" for direct lending by the central bank to private banks (Ito, 1992, Ch.5).…”

“…Rolling regressions by Muscatelli et al (2002) indicate that activism of all inflation-targeting countries examined in their paper increased toward the end of their sample period (1999Q2). We try to interpret why activism has declined (but not much in some countries) in terms of the constraints of an inflation target range in the following sections.…”

“…Following Muscatelli et al (2002), we use an unobserved component model as an alternative form of forecasting inflation. The inflation rate π t is decomposed into the underlying level µ t and a random white noise error term ξ t as:…”

What Does Monetary Policy Reveal about Central Bank's Preferences?

“…1 These include Bernanke and Mihov (1998), and Bagliano and Favero (1998) who specify the policy rule as a part of monetary policy vector autoregressions; Judd andRudebusch (1998), andGertler (2000) that formulate a simple ad-hoc reaction function; and Rudebusch (2001a), and Muscatelli, Tirelli and Trecroci (2000) who model an optimal state-contingent feedback rule, among many others.…”