RDP 9701: Inflation Regimes and Inflation Expectations 2. Literature Review

2.1. Models of Inflation

The literature on models of inflation is too voluminous to review in depth here. For the purposes of this paper, we are less interested in the dynamic interactions of inflation and other variables over the business cycle and more interested in the determination of the rate of inflation in the long run. Driffill, Mizon and Ulph (1990) and Woodford (1990) provide surveys of the theoretical and empirical literature on the costs and benefits of inflation. Unfortunately, the only conclusion that comes close to achieving a consensus is that inflation variability per se is harmful and that central banks should stabilise the inflation rate to the extent that they can without inducing costly variability in other economic variables. No consensus exists on the optimal steady-state rate of inflation.

Fischer (1990) surveys the literature on the institutional framework of monetary policy and the determination of the long-run inflation rate. The treatment is purely theoretical and focuses on the issue of ‘rules versus discretion’. A basic conclusion is that a pure rule-based policy has not existed since the Gold Standard, and many would argue that even under the Gold Standard there was a substantial discretionary aspect to monetary policy. One drawback of discretionary policy setting is that no one has designed an institutional framework that indisputably avoids the potential inflationary bias created by the time inconsistency problem.^[4]

More recently, attention has focused on the adoption of explicit inflation targets by a number of central banks. Walsh (1995) discusses the circumstances under which explicit inflation targets and enforcement clauses in the central bank governor's contract are optimal. For a brief review of the international policy debate, see International Monetary Fund (1996). At this stage it appears to be too soon to conclude much about the desirability and durability of inflation targeting.

Empirical analyses of the long-run properties of inflation rates have generally occurred in the context of the real interest rate literature. See, for example, Rose (1988) and Mishkin (1992). Using data from the entire postwar period, one cannot reject a unit root in inflation for most industrial countries using standard Augmented Dickey-Fuller tests. However, for many countries one can reject non-stationarity of the inflation rate in certain subsamples.

Hassler and Wolters (1995) and Baillie, Chung and Tieslau (1996) use the Phillips-Perron test and the KPSS test on postwar monthly inflation rates and reject both a unit root and stationarity for several countries. To reconcile these conflicting findings they turn to models with ‘fractional integration’ and find that they are strongly supported by the data. Fractional integration allows for slow mean reversion that does not decay as rapidly as the asymptotically exponential pattern associated with standard autoregressive-moving average models. This slow mean reversion is termed ‘long memory’.

Other researchers have sought to explain the apparent non-stationarity of inflation as the result of regime shifts in the mean and variability of the inflation rate. Chapman and Ogaki (1993), Bai and Perron (1995) and Hostland (1995) find significant evidence of regime shifts in US, UK, and Canadian inflation. Evans and Lewis (1995), Ricketts and Rose (1995) and Simon (1996) estimate Markov-switching models for inflation in the G7 countries and Australia. At least two regimes are significant in all countries except Germany.

Occasional shifts in the inflation regime are more economically interpretable than fractional integration. Moreover, if there are only a small number of regimes that cycle back and forth, or if the regime-generating process is stationary, inflation rates will appear to have long memory, which is consistent with the fractional integration literature.

2.2. Evidence from Bond Markets

Instead of modelling the inflation process, a more direct way to learn about long-run inflation expectations is to examine the inflation premia in long-term bond markets. Fuhrer (1996) shows that the pure expectations theory of the term structure fits better when one allows structural breaks in the Fed reaction function, especially the implicit inflation target. Gagnon (1996) shows that the inflation premium in long-term interest rates is more closely correlated with a long backward average of inflation than a short backward average, implying that there is long memory in long-run inflation expectations and/or the inflation risk premium.

Focusing directly on countries that have announced explicit inflation targets, Ammer and Freeman (1995) and Freeman and Willis (1995) provide evidence that announced inflation targets have not been fully credible in terms of lowering long-term inflation expectations implicit in bond yields down to the official target range for inflation.

Footnote

The time inconsistency problem refers to the temptation for a central bank to induce extra output by creating more inflation than the public expects, even though it knows that this extra output cannot be sustained in the long run. [4]