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Inflation targeting matters: evidence from OECD economies' sacrifice ratios.

Article Excerpt
IN Tim LAST 15 years, many countries adopted formal inflation targeting (IT) regimes in order to--attain-or lock in--price stability. However, in spite of its growing popularity among policymakers and academics alike, there is scant evidence lending credence to IT's alleged benefits. Ball and Sheridan (2003), for instance, showed that whether an Organisation for Economic Co-operation and Development (OECD) country inflation targets or not does not seem to make any difference in terms of various economic indicators such as average inflation, inflation volatility, interest rate volatility, and growth volatility. (1) The title of their paper is indeed provocative: "Does Inflation Targeting Matter?" Here, we present new cross-country evidence suggesting it does. We show that OECD countries using IT suffered smaller output losses during disinflationary periods. This result remains even after controlling for possible selection bias.

It is commonly argued that enhanced communication and accountability of the central bank under IT, coupled with explicit (firing the central banker) or implicit (damaging personal reputation) costs for missing the target should make the announced inflation objective more credible and hence disinflations less costly. In accordance with a simple augmented Phillips curve, if expected inflation converges to the actual inflation more rapidly in IT countries, mean output losses should be smaller in this group. In this paper, we use data from 61 disinflations in OECD economies to evaluate the validity of this claim. We assess whether sacrifice ratios--loss of output to trend divided by the fall in inflation--in targeting countries are lower than in nontargeting ones after controlling for nominal rigidity, velocity of the disinflationary process, public indebtedness, and a measure of monetary policy transparency.

However, since the decision to become an inflation targeter is probably enogenous, simple OLS estimations may be plagued with selection bias. To address this potential problem, we first estimate a probit model where the dependent variable is an inflation targeter dummy and the regressors are past average inflation and public debt. Based on its results, we compute for each country in our sample an inverted Mill's ratio and add it to our basic regression. This Heckman two-stage procedure yields a more reliable estimate of the relationship between the IT dummy and sacrifice ratios.

Summing up our results, we find that: (i) countries with higher average past inflation and lower debt levels are more likely to adopt IT, and (ii) inflation targeters do experience less acute output losses during disinflations even after controlling for self-selection. Importantly, this second result is not only statistically but also economically significant.

The rest of the paper is structured as follows: Section 1 briefly revises the literature on the determinants of the sacrifice ratio, Section 2 presents ordinary least squares (OLS) results linking IT to sacrifice ratios, in Section 3 we estimate a probit model in order to determine what variables increase the likelihood a country will end up as an inflation targeter, in Section 4 we apply Heckman's procedure to assess if our results in Section 2 are due to selection bias, and Section 5 briefly concludes.

1. LITERATURE

Empirical work has shown that disinflating is no free lunch and usually involves important short-run output losses that, in turn, are politically costly and can act as a deterrent to the achievement of low inflation. It is hence clearly relevant to understand what determines the so-called "sacrifice ratio" (accumulated loss in output during disinflations divided by the overall fall in inflation) and, in particular, to assess whether it varies across different monetary regimes.

Beginning with Ball (1994), empirical research on this topic has shown that the degree of nominal rigidity and the velocity of the disinflationary process are important covariates in regressions where the dependent variable is the sacrifice ratio. Inflation at the beginning of the disinflationary period is usually employed as a proxy for nominal rigidity: since nominal contracts tend to be shorter the higher the inflation rate, the initial level of inflation is expected to be negatively correlated with the sacrifice ratio. The velocity of...

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