RDP 2004-04: Inflation Convergence Across Countries 1. Introduction

For most industrialised countries, including Australia, the period since the early 1990s has been a period of low and stable inflation. While a number of factors, such as economic reforms and globalisation, enabled low inflation to persist over this period, there were also some important developments in monetary policy: a number of countries adopted formal inflation targets as the benchmark for policy, and the Economic and Monetary Union (EMU) convergence process provided similar policies in continental Europe.^[1] A number of authors (including King 1997; Brooks 1998; Bernanke et al 1999; Corbo, Landerretche and Schmidt-Hebbel 2002) have observed that those countries that adopted explicit inflation targets experienced substantial falls in their average rate of inflation. They argue that inflation targeting was (at least partly) responsible for the large degree of disinflation. In contrast, Ball and Sheridan (forthcoming) provide a different interpretation of the 1990s disinflation by arguing that inflation-targeting countries experienced a large fall in inflation because they had a higher rate of initial inflation relative to other industrialised countries. They label this phenomenon ‘regression to the mean’, or as referred to here, inflation convergence.

This paper explores the inflation convergence concept put forward by Ball and Sheridan in more detail. It suggests that rather than being a merely statistical phenomenon as implied by Ball and Sheridan, the observed convergence in inflation rates is perhaps better thought of as having been brought about by the decisions of policy-makers.

Section 2 briefly reviews Ball and Sheridan's analysis, and then explores the theoretical case for the inflation convergence result. Section 3 examines the robustness of the convergence result by replicating Ball and Sheridan's methodology out-of-sample. An explanation linking inflation convergence with monetary policy is presented through a historical analysis of policy regimes in Section 4. Section 5 then looks for evidence to support this alternative explanation by examining inflation convergence within US metropolitan regions, followed by the conclusions in Section 6.

Footnote

Rogoff (2003) provides a general discussion of the factors behind the global fall in inflation over the last decade. [1]