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I would like to thank—without implicating them in any way—Bankim Chadha, Carlo Cottarelli, Michael Deppler, Helge Berger, Mads Kieler, Roberto Motto, Kevin Ross, Massimo Rostagno, and Mark Stone. An earlier version of this paper was published as Chapter II of Country Report No. 02/236, which was released on the IMF’s website on October 29, 2002 ((www.imf.org).
ECB (1999, p. 47). In December 1998, the Governing Council set a reference value for M3 growth at 4½ percent, reflecting assumptions of 2–2½ percent growth of real potential output and a trend decline in M3 velocity of ½–1 percent. The specified ranges for output and velocity growth in combination with the 4½ percent reference value are consistent with a commitment to aim at a long-run inflation range of 1–2 percent.
Under the second pillar, ECB staff started publishing macroeconomic projections in December 2000, providing a range forecast for inflation according to the Harmonized Index of Consumer Prices (HICP) assuming constant policy interest rates.
Carare and Stone (2003) classify inflation targeting regimes into “full-fledged,” “eclectic,” and “lite” depending on the clarity and transparency of the central bank’s inflation target.
See, for example, the unobserved components analysis of the U.S. business cycle in Harvey and Jaeger (1993).
Inflation rates are based on the price deflator for private consumption expenditure. The reference to “good fit” is relative to more general ARMA models of inflation, with the degree of fit measured by conventional information criteria. There is, however, evidence that modeling π* as a time-varying inflation objective (e.g., as a random walk) would improve the fit of the equations for most countries, but without affecting the substance of the conclusions.
This is a stylized characterization of actual practices as regards point targets, target ranges, and target horizons. See Schaechter, Stone, and Zelmer (2000, pp. 6-14) for descriptions of inflation targeting practices.
Low persistence of the inflation process appears indeed to be the hallmark of the (very) short-time series on inflation generated by the inflation targeting regimes in New Zealand, Canada, the United Kingdom, and Sweden since 1993: estimates of AR(1) processes for these countries’ annual CPI data suggest that ση was generally in the range 0.75–1.00 while ϕ was close to zero (if not negative in some countries) during 1993-2001.
Shocks to difference-stationary time series processes have permanent effects only on the level of the series, but their growth rates are stationary around a constant mean.
Christiano and Rostagno (2001) study several analytical examples illustrating that monitoring money growth can be a good insurance practice for monetary policy; in their examples, following an inflation targeting (Taylor) rule can leave the economy without a long-run anchor.
In fact, Calvo and Reinhart (2002) suggest that “fear of (exchange rate) floating” tends to be associated with low credibility, high pass-through to price, and inflation targeting.
Lucas (1980) used frequency domain techniques to study the long-run link between money and inflation. Gerlach (2003) adopts a “frequency domain approach” to derive estimates of a “two-pillar” Phillips curve for the euro area, with inflation linked to money in the long run but to the output gap in the shorter run.
The results of frequency domain analysis based on small sample sizes can be quite sensitive to prefiltering (“prewhitening”) of the data and the “spectral window” used for calculating the crossspectrum. Robustness analysis suggested that the lower-frequency results shown in Figures 3-4 are quite sturdy, but the coherence estimates at the business-cycle frequency can be sensitive to prefiltering without affecting the overall conclusions.
The part of this section on the Bundesbank’s monetary targeting experience considers an approach to modeling inflation expectations and credibility that allows time-variation in ϕ.
Because the analysis uses annual data, the HP-filter smoothing constant was fixed at 100. A more subtle approach would base the long-run estimates of velocity and potential output on explicit unobserved components modeling—but the gains in insights relative to using the paper’s simple HP-filtering approach appear to be modest.
All data series are taken from the European Commission’s database. The change in the terms of trade is the difference between export and import price inflation for goods and services.
Germany’s year-on-year inflation targets implicit in the money growth targets (base money during 1974-87 and M3 during 1988-98) during this period were at times above 2 percent.
The opposite view, namely that the Bundesbank’s monetary policy strategy succeeded despite its monetary targeting approach, has, however, many adherents.