The role of short-run inflation targets and forecasts in disinflation

Working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 18 October 2002

Working Paper no. 167
By Lavan Mahadeva and Gabriel Sterne

Globally, the majority of countries using inflation targets have done so when inflation was neither low nor stable. Many such countries have changed their target each year, and our empirical estimates support theoretical predictions that annual changes to the target are endogenous to outcomes. We use a unique cross-country panel dataset of inflation targets and outcomes in 60 countries in the 1990s. Our estimates suggest the target revision may be predicted according to a simple ‘forecasting’ rule, and depends upon the outcome’s deviation from both the short-run and long-run target. During disinflation, policy-makers may therefore be characterised as using two types of policy rule; one for setting interest rates, the other for revising annual targets. In designing roles for the legislator and the central bank in the monetary framework, it is necessary to take into account the likelihood that the process of setting the target may, in some circumstances, be inseparable from that of setting policy instruments. In the light of other literature, we also argue that during disinflation, short-run targets may help central banks to build credibility because they may increase transparency.

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