Inflation Targeting as a Shock Absorber

Abstract

We study the characteristics of inflation targeting as a shock absorber, using quarterly data for a large panel of countries. To overcome an endogeneity problem between monetary regimes and the likelihood of crises, we propose to study large natural disasters. We find that inflation targeting improves macroeconomic performance following such exogenous shocks. It lowers inflation, raises output growth, and reduces inflation and growth variability compared to alternative monetary regimes. This performance is mostly due to a different response of monetary policy and fiscal policy under inflation targeting. Finally, we show that only hard but not soft targeting reaps the fruits: deeds, not words, matter for successful monetary stabilization.

Rare Disasters, the Natural Interest Rate and Monetary Policy

“…Conversely, inflation targeting calls for an immediate increase of the policy rate despite the drop in output in order to mitigate the inflationary pressures. This is consistent with the empirical evidence in Fratzscher et al (2020), who estimate that in inflation targeting countries inflation rises only modestly, contrary to what happens under alternative regimes (they estimate an increase of annualized inflation of 0.56 percentage point in inflation targeting countries against 3.2 percentage points in non inflation targeters).…”

“…Turning to the monetary policy responses, Keen and Pakko (2011) use a standard DSGE model to compute the optimal monetary policy response to a small natural disaster and conclude that it is optimal to raise the policy rate. 12 Consistent with these theoretical results, Fratzscher et al (2020) and Klomp (2020) estimate an increase in the policy rate to contain inflation in countries adopting inflation targeting. However, these findings seem to contrast with available evidence on the central banks' behavior in response to natural disasters.…”

“…While some papers support the view that natural disasters (as well as wars) are negative supply shocks, with capital destruction and higher natural rate and inflation (see e.g. Heinen et al, 2018;Fratzscher et al, 2020 andJorda et al, 2020), they may entail larger demand-side effects with inflation falling and central banks responding by implementing expansionary policies. 38 It is therefore interesting to explore what would happen should demand-side effects prevail on the supply-side effects a disaster realization.…”

“…Parker (2018) and Klomp (2020) find a positive and significant response only to extreme events in advanced economies. Accordingly, Fratzscher et al (2020) estimate only modest increases of inflation in countries adopting an inflation targeting regime, which are mainly advanced economies. Using evidence on the 2011 earthquake in Japan, Wieland (2019) shows how negative supply shocks are contractionary and inflationary at the zero-lower-bound.…”

Point targets, tolerance bands or target ranges? Inflation target types and the anchoring of inflation expectations

“…While there are also critics of IT (e.g. , Frankel 2012), its proponents have praised it as a framework that lowers and stabilises inflation (e.g., Angeriz and Arestis 2008;Vega and Winkelried 2005) and anchors inflation expectations (Gürkaynak et al 2010), while at the same time providing a credible framework that helps making central banks accountable (Bernanke and Mishkin, 1997;Ball, 2010), raising output growth in response to large adverse shocks (Fratzscher et al 2020) and even eradicating international financial crises (Rose 2020).…”