An initial look suggests that inflation targeting has been a success: inflation was within or below the target range for all targeting countries, and noticeably below the countries' average inflation levels of the 1970s and 1980s. The macroeconomic baselines shown in the chart series in Parts III-VI of this study indicate that the reduced inflation levels in these countries were sustained without benefit or harm from unusual macroeconomic conditions.
In New Zealand, the disinflation during the four years prior to target adoption was accompanied by a period of sluggish GDP growth and, since 1988, rising unemployment. The continuation of the disinflation during 1990-91, amid recession in many other Organization for Economic Cooperation and Development (OECD) economies, led to recession and sharply rising unemployment. In Canada, the disinflation was achieved along with continued progress in lowering unemployment, only a brief spike in nominal interest rates, and continued positive, though slowing, growth. Similarly, in the United Kingdom, the disinflation begun two years prior to target adoption (during membership in the Exchange Rate Mechanism) continued against a background of improving growth, falling unemployment, and much lower nominal interest rates in the wake of the United Kingdom's exit from the European Monetary System.
Yet, while the reduction of inflation in these three countries represents a genuine achievement, it is not clear whether the reduction was the result of forces that had already been put in place before inflation targeting was adopted. Did the adoption of an inflation target in the countries considered here have an effect on inflation and on its interaction with real economic variables? In this section, we provide some tentative evidence on this question by undertaking a very simple forecasting exercise. (Additional evidence from a wider range of statistical investigations on a larger set of countries is found in Laubach and Posen [1997b].) We estimate a three-variable unrestricted vector autoregression (VAR) model of core inflation, GDP growth, and the central bank's overnight instrument interest rate from the second quarter of 1971 to the date of target adoption; we then allow the system to run forward five years from the time of target adoption, plugging in the model's forecast values as lagged values.(1)
This exercise is meant to give a quantitative impression of whether the interaction between inflation and short-term interest rates exhibits a pattern of behavior after the adoption of the inflation target that differs markedly from the pattern before.(2) The unconditional forecast of each variable represents the way we would expect the system to behave in the absence of shocks from the situation at the time of target adoption. The comparison between what actually happened to these variables and their unconditional forecast is reasonable for the early 1990s, given the absence of major supply and demand shocks since adoption for the three inflation targeters we examine.(3)
In the three countries adopting inflation targets, disinflation through tighter monetary policy had largely been completed by the time the target was adopted, allowing interest rates to come down. (The year or so of further disinflation appears to be attributable to prior monetary policy moves, given policy lags.) This sequence of events is consistent with our finding in the case studies that countries adopted targets when they wished to lock in inflation expectations at a low level after a disinflation. …