Winning Proposal to the Pierce Scholar's Fund: 2010 Competition

Project Title: Calling the Shot: The Political Economy of Inflation Targeting

Faculty Sponsor and PI: Andrew Kerner

Ph.D. Student: Alton B.H. Worthington

Project Description

Inflation expectations are an important part of economic decision making for consumers andproducers in any economy. One option governments and/or central banks have for reducing the uncertainty about inflation risks is issuing public pronouncements of inflation targets. In practice, implementation of inflation targeting (IT) policies varies across space and time and targets can take the form of a point target or a range target. Although IT is a relatively recent innovation in state economic policy (New Zealand pioneered the practice during central banking reforms in 1989-1990), its intellectual pedigree extends back to Keynes' work in the 1930s. In theory, these policies give economic actors additional information about future nominal prices and stabilize investment by reducing uncertainty over inflation rates.

Most academic work on IT has been conducted by economists and economic historians and focuses on IT’s technical aspects (Walsh 1995; Svennson 1997, 1998, 2000, 2002) and evaluations of its success compared to stated aims (Bernanke et al. 1999; Bernanke and Mishkin 1997). Political factors have largely been ignored in evaluating the various ways countries approach IT and the efficacy of these policies. However, there are a myriad of reasons to suspect that politics plays a large role in determining both the type of IT policies put into place and their success.

We are centrally interested in exploring two dynamics. First, we suspect that the success of IT depends greatly upon policy credibility (market actors need to believe that inflation targets will be met) and that the credibility necessary to make IT work is deeply informed by political factors. Second, we suspect that the choice of IT strategy (point targets vs ranges) is the product of a strategic interaction between governments and central bankers with potentially divergent preferences regarding the tradeoffs between stability in inflation expectations and leeway for governments and central bankers to pursue counter-cyclical inflationary strategies. We are particularly interested in exploring these questions with respect to the impact of the partisan composition of governments, the distribution of societal interests for and against strict inflation targets and the institutional context in which the government and central bank reside.

The specific questions we aim to address are:

  • Why do states choose to implement inflation targeting?
  • How (if at all) do inflation targets constrain governments? How do these differ from those imposed by other central bank goals?
  • Do domestic investors, voters, or foreign investors view these stated targets as credible promises or cheap talk? Does partisanship alter these expectations in a meaningful way?
  • Does point-targeting represent a stronger promise to austerity than a range? Do governments act strategically when choosing how and when to announce inflation targets?

The first objective of this project is to create a dataset of policy announcements in a sampling frame of both inflation targeting states and states where central banks issue other forms of announcements (policy announcements, economic outlooks, etc.) from 1990 until the present. This should comprise about 40% of the work to be done during Summer 2010. Concurrent with the development of this dataset, research and collaboration time will be divided among further background research into the theory and practice of IT and the refinement our theory. Our initial expectation is that governments and central banks recognize the potential for their inflation targets to be viewed incredulously by the market, and will adjust their inflation targets accordingly. We suspect that these adjustments will manifest in both the level of inflation targeted and the manner (point vs range targets) that in which the inflation target is set. As such, we expect to derive a theory in which policy statements and market reactions are endogenously determined. We are particularly interested in developing and testing a set of hypotheses investigating the effects of interest group strength and government partisanship on the credibility of inflation targets. Much of the extant political economy literature assumes that labor constituencies and left governments are more likely to accept deficits and prefer full employment policies to low inflation. If this is the case, we would expect that when left governments are in power (or even appear likely to enter power) that the credibility of targets will fall. This should have an effect on central bank behavior vis-à-vis the use of point target vs ranges.

Having developed our dataset and theoretical expectations, the remaining 60% of our time will be spent preparing a conference paper focused on the credibility of inflation targets to be presented at a political economy conference in the 2010-2011 academic year. This should be followed by submission to a peer-reviewed journal. If this research proves fruitful, this project will form the basis for a larger research agenda for Alton. That expanded project will expand the sampling frame and extend the data back to 1970. Upon completion of the initial research, the data and findings will be made publicly available.