Inflation Targeting as a Shock Absorber

60 Pages·2017·2.71 MB·English

Inflation Targeting as a
Shock Absorber

Marcel Fratzscher1, Christoph Grosse Steffen2,
& Malte Rieth3
December 2017, WP #655
ABSTRACT
We study the characteristics of inflation targeting as a shock absorber in response to large
shocks in the form of natural disasters for a sample of 76 countries over the period 1970-
2015. We find that inflation targeting improves macroeconomic performance following
such shocks as it lowers inflation, raises output growth, and reduces inflation and growth
variability compared to alternative monetary regimes. This performance is mostly due to a
stronger 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.
Keywords: Monetary policy, Central banks, Monetary regimes, Dynamic effects
JEL classification: E42 ; E52 ; E58

1 DIW Berlin, Humboldt-University Berlin, CEPR, [email protected]
2 Banque de France, Monetary policy and financial research dept., Christoph.Grossesteffen@banque-
france.fr
3 DIW Berlin, [email protected]
Acknowledgements. We are thankful to Philippe Andrade, Agnès Bénassy-Quéré, Kerstin Bernoth, Fabio
Canova, Michael Burda, Boris Hofmann, Athanasios Orphanides, Guillaume Plantin, Christian Proano,
Federico Ravenna, Willi Semmler, Lutz Weinke and to participants of seminars and conferences at
Computing in Economics and Finance New York USA 2017, International Association of Applied
Economics Sapporo Japan 2017, Banque de France, DIW Berlin, and Humboldt University Berlin for useful
comments and suggestions.
Working Papers reflect the opinions of the authors and do not necessarily express the views of the Banque de
France. This document is available on publications.banque-france.fr/en
Banque de France WP #655 December 2017
NON-TECHNICAL SUMMARY
Inflation targeting has been praised for its success in bringing down inflation and raising
credibility and accountability of policymakers. The costs of “cleaning up” after the global
financial crisis, however, dramatically changed the perception of IT, since it may disregard
the build-up of financial imbalances through its narrow focus on consumer price
developments. As a result, scholars and policymakers today call for a refinement of the IT
framework by allowing for more flexibility.
This paper exploits the exogenous occurrence of natural disasters in order to answer the
question whether countries operating under IT have a better macroeconomic performance
in response to large adverse shocks than those with alternative regimes. We document
important differences in the dynamic responses of countries under IT (targeters) and under
alternative monetary regimes (non-inflation targeters) to large natural disaster shocks
(Figure below).
Level effect of large natural disaster shocks in targeting
and non-inflation targeting economies

Note:
The figure shows the response of the level (cumulated first (log) difference) of key macroeconomic variables in both
tSaorugrectien:g F (rdaatrzks cshheard, eGd raorsesae) Santedf fneonn -ainndfl aRtiioenth t a(r2g0e1t7in)g countries (light shaded area) to large natural disasters over the
period 1970Q1-2015Q4. Statistical inference is based on 500 Monte-Carlo draws.
Targeters perform significantly better rega rding both the level and the volatility of output
and prices. While GDP drops immediately under both regimes, the initial decline is smaller
under IT and the subsequent recovery is stronger and faster. Four years after the shock,
output is about two percentage points higher than under alternative regimes. Moreover,
Banque de France WP #655 ii
consumer prices increase significantly less for targeters. The difference to non-targeters is
about six percentage points after four years.
The results suggest that targeters rely on a different monetary-fiscal policy mix. The policy
responses also significantly lower the shock-induced volatility of changes in output,
consumer prices, consumption and investment relative to non-targeters. Lower volatility, in
turn, is associated with smaller countercyclical private credit risk and lower term premia.
The stability of consumer prices, in particular, translates into a more stable real exchange
rate and implies relatively higher export and lower import growth under IT.
Finally, we show that only hard but not soft targeting reaps the fruits: deeds, not words,
matter for successful monetary stabilization. The paper provides an analysis of the
mechanisms behind these results, as well as extensive robustness checks.
The findings of the paper have a number of implications for central banks. They show that
while IT may not strictly be a superior policy mandate in open economies in normal or
tranquil times - as shown by the existing literature - it is a better mandate in crisis times, at
least when the domestic economy is hit by a large real shock, such as a natural catastrophe.
The better adjustment to large natural disasters of IT countries also suggests that IT has
been more of a savior during the Global Financial Crisis than thought.
However, this holds only if a central bank does not merely pretend to follow an IT strategy,
but if it has gained credibility through a successful track record on IT. Therefore, it should
be considered in the debate on reforming the present IT frameworks toward more
flexibility that allowing for prolonged deviations from the target range come at a cost in
terms of lower shock resilience.

Ciblage d’inflation comme
absorbeur des chocs économiques
RÉSUMÉ
Nous étudions les caractéristiques du ciblage de l'inflation en tant qu'amortisseur en
réponse à de grands chocs sous forme de catastrophes naturelles pour un échantillon de
76 pays sur la période 1970-2015. Nous constatons que le ciblage de l'inflation améliore la
performance macroéconomique à la suite de tels chocs car il réduit l'inflation, augmente la
croissance de la production et réduit l'inflation et la variabilité de la croissance par rapport
aux régimes monétaires alternatifs. Cette performance est principalement due à une
réponse plus forte de la politique monétaire et de la politique budgétaire dans le cadre du
ciblage de l'inflation. Enfin, nous montrons que seul le ciblage stricte mais pas le souple est
fructueux: les actes, pas les mots, sont importants pour une stabilisation monétaire réussie.

Mots-clés : Politique monétaire, Banques centrales, Régimes monétaires, Effets dynamiques

Les Documents de travail reflètent les idées personnelles de leurs auteurs et n'expriment pas nécessairement
la position de la Banque de France. Ils sont disponibles sur publications.banque-france.fr

Banque de France WP #655 iii
1. Introduction
Inflation targeting has become a dominant framework for monetary policy
over the last two decades. It has been praised for its success in bringing down
inflation and raising credibility and accountability of policymakers (Bernanke
and Mishkin, 1997; Ball, 2010). Its popularity has been reflected in an increasing
number of countries adopting inflation targeting (IT) at the end of 2015. The
global financial crisis has, however, dramatically changed the perception of IT as
an optimal framework for achieving macroeconomic stability, in particular at
times when the economy is confronted with large real or financial shocks. It has
been argued that IT, by focusing narrowly on inflation, may contribute to a
build-up of financial instability (Taylor, 2007; Svensson, 2010; Frankel, 2012),
lead central banks to neglect other important objectives, such as employment
(Stiglitz, 2008), and constrain monetary authorities in dealing with deep
recessions (Borio, 2014). As a result, scholars and policymakers call for a
refinement of the IT framework to allow for more flexibility (Svensson, 2009).
Many studies have analyzed whether inflation targeting affects the economic
performance of a country, though no clear-cut consensus has emerged in the
literature (Walsh, 2009; Ball, 2010). The focus of most papers in this literature
has been on the performance of IT regimes during the relatively good times of
the 1990s and till the beginning of the 2008 global financial crisis. During those
two decades of the “great moderation”, with declining and low inflation rates
amid strong economic growth, only few countries operating under an IT regime
experienced a deep economic or financial crisis. A different and arguably at least
equally important question is whether IT helps countries and their central
banks in dealing with crises, that is, whether it allows them to stabilize inflation
and output in response to large adverse shocks.
This paper focuses on this question and analyzes whether countries operating
under IT have a better macroeconomic performance in response to large
adverse shocks than those with non-IT regimes. Thereby, we empirically
respond to the question whether IT is a perpetrator, bystander or savior in the
wake of a crisis (Reichlin and Baldwin, 2013). We limit the analysis to the effects
of natural disasters, such as earthquakes or windstorms, as these are the most
1
exogenous large adverse shocks that can be identified and as they have been
shown to have a large impact on the macro-economy (Noy, 2009). Natural
disasters have a direct negative effect through the destruction of physical capital
and durable consumption goods such as housing and cars. The analysis can be
extended to include other types of shocks, such as financial shocks and other
real shocks, though this would entail the risk of endogeneity to the monetary
policy regime. At the same time share natural disaster shocks patterns with
shocks to the depreciation rate of capital or the quality of the capital stock that
have been used for the analysis of financial crises (Liu et al., 2011).
Natural disasters can be considered exogenous to the choice of the monetary
regime because they are largely unpredictable and not caused by economic
conditions. These features allow us to identify the conditional effects of IT using
relatively weak and verifiable assumptions about the distribution of the
unobserved factors that determine macroeconomic outcomes and about the
systematic relation between natural disasters and monetary regimes. In terms
of the treatment literature, we assume that conditioned on country
characteristics the “treatment” in form of a natural disaster is random, but
instead of focusing on the effects of the treatment, we are interested in whether
alternative monetary regimes imply different responses to the treatment.
To obtain a measure of such shocks, we use the reported insurance damage, in
percent of national GDP, from the EM-DAT dataset, which globally documents
natural disasters. As we are specifically interested in large real shocks, we focus
on disasters in the upper half of the disaster frequency distribution associated
with large declines in GDP. We match the shocks with quarterly macroeconomic
data for 76 countries over the period 1970Q1-2015Q4. We then estimate a set of
panel models similar to the single-equation regressions of Romer and Romer
(2004) and Kilian (2008), but extend this to a panel framework, to trace out the
responses of key macroeconomic variables to the shocks. The models contain
country fixed-effects as well as time-varying control variables that account for
alternative mechanisms which could impact and interact with the transmission
of natural disaster shocks.
We find that a natural disaster shock is contractionary and inflationary on
impact, followed by a short-lived boom in consumption and investment activity.
2
The empirical pattern resembles an adverse supply shock in a New Keynesian
model due to a destruction of physical capital and a decline in productivity,
followed by a subsequent positive demand shock (Smets and Wouters, 2007;
Keen and Pakko, 2011). The interpretation as an adverse supply shock is in line
with microeconomic evidence hinting toward economic disruptions that cause
indirect losses due to natural disasters. Inoue and Todo (2017) show that the
Great East Japan earthquake of 2011 was propagated via supply chain
disruptions to other regions. The substitution of production inputs poses a drag
on firm productivity. The subsequent investment boom can be understood
through the lens of the Solow (1956) growth model. A destruction of the
physical capital stock leads to a relative scarcity of capital for production which
induces catch-up growth through investment. Further, a destruction of durable
consumption goods likewise prompts a rise in private consumption.
We document important differences in the dynamic responses of countries
under IT (targeters) and under alternative monetary regimes (non-inflation
targeters) to large natural disaster shocks. Targeters perform significantly
better regarding both the level and the volatility of output and prices. While
GDP drops immediately under both regimes, the initial decline is smaller under
IT and the subsequent recovery is stronger and faster. Four years after the
shock, output is about two percentage points higher than under alternative
regimes. Moreover, consumer prices increase significantly less for targeters. The
difference to non-targeters is about six percentage points after four years.
These dynamics are reflected in statistically and economically significant
differences across monetary regimes in average GDP growth and inflation
following large shocks. The average quarterly growth rate of output is 0.2
percentage points higher under IT, and the average inflation rate is 0.4
percentage points lower. Moreover, there is robust evidence that inflation
targeters are more successful in stabilizing both output growth and inflation.
The standard deviation of both variables in the four years following a natural
disaster is only half of the size as under alternative monetary regimes.
While the main aim of the paper is to provide these stylized facts and we are
agnostic about the precise channels leading to the main results, we also provide
evidence on the potential mechanisms through which IT affects the adjustment
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process to large shocks. The results suggest that targeters rely on a different
monetary-fiscal policy mix, they profit from reduced macroeconomic volatility
and lower financial frictions, and their external sector provides a better buffer.
Most strikingly, targeting central banks tighten monetary policy more or
loosen it less following the adverse shock to stabilize inflation, while fiscal
policy is accommodating. We interpret these findings in the light of a
coordinating role of IT for monetary and fiscal policy. A higher coefficient on
inflation in the loss function of central banks enforces a sound fiscal position
which, in turn, prevents from pro-cyclical public spending in the wake of large
disasters. Importantly, our regressions control for the institutional quality,
which are often held responsible for pro-cyclical fiscal policy in middle-income
countries (Frankel et al. 2013).
The policy responses also significantly lower the shock-induced volatility of
changes in output, consumer prices, consumption and investment relative to
non-targeters. Lower volatility, in turn, is associated with smaller
countercyclical private credit risk and lower term premia. The stability of
consumer prices, in particular, translates into a more stable real exchange rate
and implies relatively higher export and lower import growth under IT.
In contrast, non-targeting monetary authorities tend to ease policy more
aggressively and persistently in an effort to stabilize output, while fiscal policy is
contractionary. The adverse effects of private credit risk and term premia
reduce the effectiveness of monetary policy and this policy mix induces lower
output growth and higher consumer price inflation. Macroeconomic volatility is
also higher for non-targeters, and the strong increase in inflation leads to a
significant real appreciation of the currency.
Finally, we find that the better macroeconomic performance is only realized
by hard targeters that mostly comply with their inflation targets. There is only
limited evidence that countries which have introduced inflation targeting, but
deviate from their target for a prolonged period of time, reap the fruits of an
enhanced conditional macroeconomic performance. Here, compliance with an
inflation target is measured as the maximum period of consecutive recordings
of inflation rates outside of the target corridor in percent of periods since IT has
been introduced. This difference between hard and soft targeting is important
4
as it suggests that it is not the fact that a central bank formally adopts IT that
allows a superior performance. But this finding suggests that it is the track
record and the ensuing credibility of an IT central bank that allows it as well as
the fiscal authorities to respond differently and more successfully to the
economic shock of a natural disaster.
Our paper relates to a large literature on the impact of IT on macroeconomic
outcomes. In a seminal contribution, Ball and Sheridan (2004) find no
significant differences between IT and non-IT countries, as measured by the
behavior of inflation, output, and interest rates, in a sample of OECD member
states and based on a difference-in-difference approach that controls for
regression to the mean. Similarly, Lin and Ye (2007) detect no effect of IT on
either inflation or inflation variability in industrial countries when employing
propensity score matching methods. Using OLS to study the impact of IT on
disinflation periods in OECD countries, Brito (2010) concludes that inflation
targeters were not able to bring inflation down at less output costs than non-
targeters. On the other hand, Gonçalves and Carvalho (2009) find in a sample of
OECD countries that inflation targeters suffer significantly smaller output losses
for bringing down inflation when controlling for possible selection bias through
Probit or Heckman regressions. Moreover, Lin and Ye (2009) and Lin (2010)
show evidence based on propensity score matching that IT does lower inflation
and inflation variability in developing countries.
These apparently contradicting findings extend to studies which focus on the
performance of IT during specific time periods and across different country
samples. Concerning the global financial crisis, Rose (2014) finds that IT did not
substantially change how a country weathered the crisis. By contrast, Carvalho
Filho (2010) and Andersen et al. (2015) present evidence that IT countries fared
significantly better than others during this episode. Regarding different country
samples, De Mendonça and e Souza (2012) find, based on propensity score
matching, that IT may be particularly beneficial in developing countries,
suggesting that IT might work if it helps improve the credibility of monetary
authorities.
To the best of our knowledge, our paper is the first one to analyze whether
inflation targeting is effective as a shock absorber in response to large real
5
shocks. Our econometric approach, which has not been used before to study the
macroeconomic impact of IT, has several advantages. First and foremost,
estimating the conditional effect of IT, given an exogenous event, bypasses the
need to directly deal with the potentially endogenous choice of the monetary
regime to macroeconomic conditions as it “nets out” the unconditional impact of
IT on the response variables. The methodological approach is inspired by
Ramcharan (2007), who uses disasters to evaluate the effects of alternative
exchange rate regimes on the adjustment to real shocks in an annual sample of
developing countries and employing pooled OLS.
The remainder of the paper is structured as follows. Section 2 formulates the
main hypotheses. It also describes the empirical strategy and the data. Section 3
contains the core results. Section 4 provides a sensitivity analysis, before the
final section concludes.
2. Empirical strategy and data
We characterize in this section potential channels for how inflation targeting
affects the policy response to and propagation of large natural disaster shocks in
an economy. This reasoning is then used to derive the empirical hypotheses. We
then describe the dataset, the data transformation and the empirical model used
to test our main hypotheses.
2.1. Inflation targeting and effects of large natural disaster shocks
We consider, in line with the literature, that natural disasters correspond to
an adverse shock to physical capital and durable consumption goods.1 The
empirical response to such a shock, which we intend to trace out in this paper,
will be affected by two factors, first the policy response to the shock, and
second, the propagation of the shock within the economy. We suppose that the
policy response and the propagation of the shock are affected by the choice of
the monetary policy regime.
Inflation targeting (IT) might affect the policy response to a natural disaster
shock along two dimensions. First, it imposes constraints on policymakers.

1 These shocks share essential features with shocks to the quality of capital or the capital depreciation rate, which have been
at the heart of the global financial crisis. One important caveat applies to this generalization. Liu et al. (2011) show in an
estimated DSGE model of the US economy that while a shock to the rate of capital depreciation is contracting output it is also
disinflationary. In contrast, our natural disaster shock leads to a rise in inflation on impact in the data, as we show below.
6
Following Svensson (2010), IT can be described as a monetary framework
under which the central bank publicly announces an official numerical target or
target range for the inflation rate over a specific time horizon. Monetary policy
under IT is therefore often described as ‘constrained discretion’ (Bernanke and
Mishkin, 1997; Kim, 2011). IT is typically associated with enhanced
communication standards of monetary authorities with the public and aims at
increasing accountability, possibly through implicit incentives or explicit
contracts for central bankers. The monetary authority also explicitly
communicates to the public that low and stable inflation is its main goal, bases
its decisions on inflation forecasts, and enjoys a high degree of political
independence.
Second, the aforementioned features in the conduct of monetary policy under
IT ideally make announced inflation targets of the central bank more credible.
The main advantage over alternative monetary regimes is thus that IT
addresses the dynamic consistency problem (Kydland and Prescott, 1977).
Clarida et al. (1999) show that stronger commitment allows the central bank to
affect agents’ inflation expectations directly. Lower and better anchored
inflation expectations, in turn, reduce the short-run tradeoff between inflation
and output (Walsh, 2009). According to a forward looking Phillips curve,
inflation depends on future output gaps. A natural disaster shock is lowering
potential output through the destruction of productive capital. All else equal,
lower potential growth closes the output gap, which ultimately raises inflation.
The central bank would like to give the signal that it will be tough in the future
without contracting demand much today. This strategy would lower inflation
today, while keeping output at potential. However, such a strategy is only
credible under commitment, which IT facilitates to attain.
Bernanke and Mishkin (1997) highlight that lower uncertainty about future
inflation supports savings and investment decisions and reduce the riskiness of
nominal financial and wage contracts. This can impact the propagation of
natural disaster shocks for two reasons. First, lower nominal uncertainty in
wage contracts might allow for higher employment in response to natural
disaster shocks. Strulik and Trimborn (2014) show in a macro model that the
GDP impact of natural disasters is affected by the households’ labor response. In
7