Some Evidence on the Efficacy of the U.K. Inflation Targeting Regime: An Out-of-Sample Forecast Approach

Abstract

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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