Changes in inflation dynamics under inflation targeting? Evidence from Central European countries

Abstract

Many countries have implemented inflation targeting in recent decades. At the same time, the international conditions have been favorable, so it is hard to assess to what extent the success in stabilizing inflation should be attributed to good luck and to what extent to the specific policy framework. In this paper, we provide a novel look at the dynamics of inflation under inflation targeting, focusing on three Central European (CE) countries that adopted the IT regime at similar times and in similar environments. We use the framework of the open economy New Keynesian Phillips curve (NKPC) with time-varying parameters and stochastic volatility to recover changes in price-setting and expectation formation behavior and volatility of shocks. We employ Bayesian model averaging to tackle the uncertainty in the selection of instrumental variables and to account for the possible country-specific nature of inflation dynamics. The results suggest that inflation targeting does not itself automatically trigger changes in the inflation process, and the way the framework is implemented might matter. In particular, we find rather heterogeneous evolution of intrinsic inflation persistence and volatility of inflation shocks across these countries despite the fact that all three formally introduced inflation targeting a decade ago.