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Some evidence on the efficacy of the UK inflation targeting regime: an out-of-sample forecast approach

  • Chan Huh
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    Inflation targeting (IT)--a policy framework that directly targets an explicit inflation goal--has gained widespread attention recently as it has been adopted by several OECD countries. There is a growing body of literature on the ultimate long-term benefits of price stability and on theoretical issues related to inflation targeting. But the short duration of this practice has limited the number of works that empirically analyze the performance of IT regimes. This paper examines the British inflation targeting experience since 1993 by focusing on the out-of-sample forecast performance of models fitted to the 1980s. The model over-predicts actual short-term and long-term interest rates, while its inflation forecast is on tract for the recent period. This implies that it took less monetary tightening to obtain a favorable inflation outcome. Identical exercises were repeated for France and the US, countries that have not adopted IT but have experienced low inflation in the recent period. The results for these countries show that recent low inflation has not been unusual when compared to forecasts from the models designed to fit the second half of the 1980s. That is, given the level of inflation, the degree of actual monetary policy tightness (measured in terms of short-term interest rate) is about what the model expects. Findings of this paper could be explained by enhanced credibility of the UK monetary policy since the adoption of IT.

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    Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 565.

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    Date of creation: 1996
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    Handle: RePEc:fip:fedgif:565
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    1. Hall, R.E. & Mankiw, N.G., 1993. "Nominal Income Targeting," Harvard Institute of Economic Research Working Papers 1650, Harvard - Institute of Economic Research.
    2. Svensson, L.E.O., 1995. "Optimal Inflation Targets, 'Conservative' Central Banks, and Linear Inflation Contracts," Papers 595, Stockholm - International Economic Studies.
    3. Thomas Doan & Robert B. Litterman & Christopher A. Sims, 1983. "Forecasting and Conditional Projection Using Realistic Prior Distributions," NBER Working Papers 1202, National Bureau of Economic Research, Inc.
    4. Svensson, Lars E. O., 1997. "Inflation forecast targeting: Implementing and monitoring inflation targets," European Economic Review, Elsevier, vol. 41(6), pages 1111-1146, June.
    5. Bennett T. McCallum, 1996. "Inflation Targeting in Canada, New Zealand, Sweden, the United Kingdom, and in General," NBER Working Papers 5579, National Bureau of Economic Research, Inc.
    6. David Mayes & Bryan Chapple, 1995. "The costs and benefits of disinflation: a critique of the sacrifice ration," Reserve Bank of New Zealand Bulletin, Reserve Bank of New Zealand, vol. 58, March.
    7. Mervyn King, 1994. "Monetary policy in the UK," Fiscal Studies, Institute for Fiscal Studies, vol. 15(3), pages 109-28, August.
    8. Sims, Christopher A, 1980. "Macroeconomics and Reality," Econometrica, Econometric Society, vol. 48(1), pages 1-48, January.
    9. Ammer, John & Freeman, Richard T., 1995. "Inflation targeting in the 1990s: The experiences of New Zealand, Canada, and the United Kingdom," Journal of Economics and Business, Elsevier, vol. 47(2), pages 165-192, May.
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