Abstract

We study whether the institutional adoption of inflation targeting (IT) has constituted both a policy and a macroeconomic switch in Sweden using the nonlinear MSVAR technique. We assess the relative weight put on inflation in the monetary reaction function and the capacity of IT to reduce macroeconomic uncertainty. We show that IT has constituted a policy switch to a lower focus on inflation, in contrast with the usual argument that has been put forth by IT opponents. Moreover, IT adoption is shown to have reduced uncertainty, through lower inflation and output variabilities simultaneously. Last, counterfactuals suggest IT provides higher monetary policy leeway.

Science Direct link: CREEL J., HUBERT P., (2012), "Constrained discretion in Sweden", RESEARCH IN ECONOMICS, March, Vol. 66, Issue 1, pp 33-44, 12 p.


Knowledge @ ESCP Europe

Economics

Constrained discretion in Sweden

Jerome Creel
Paul Hubert

This is a condensed version of the article
Jerome Creel and Paul Hubert, “Constrained discretion in Sweden”, Research in Economics, March 2012, Vol. 66, Issue 1, pp. 33-44.

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Jérôme Creel is a Professor of Economics at ESCP Europe; he joined the school in September 2007. He holds a PhD in Economics from the University of Paris-Dauphine (obtained cum laude in 1997).

At the beginning of 2012, the President of the US Federal Reserve, M. Ben Bernanke, stated that the US would now follow an inflation-targeting regime. As a scholar, M. Ben Bernanke has long acknowledged the importance of mixing rules and discretion as far as monetary policy was concerned. Rules and the discipline that they embed would improve monetary policy credibility whereas discretion would enable to dampen whatever type of shocks would hit the economy. The concept of “constrained discretion” that he promoted required the adoption of a full inflation-targeting regime. This kind of institutional setting hence required the adoption of an official inflation target and available forecasts on the economy that help anchor private expectations, and communication, transparency and accountability of the central bank to the public at large to help explain possible deviations from the inflation target.

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In this article, Paul Hubert and I wished to turn back to (recent) economic history to assess the incidence of inflation-targeting on a country, Sweden, which has adopted it in the 1990s.

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In the 1990s, Sweden experienced an institutional policy shift, from a fixed exchange rate regime to a floating exchange rate regime with an inflation target. The fixed exchange rate was abandoned in November 1992 and an inflation target was formulated in 1993, and planned to be effective from 1995 onwards. In addition, there have been two institutional shifts in fiscal policy, one with the introduction of fiscal rules in 1997 and another with the creation of the Swedish fiscal policy council in 2007. All these shifts were consistent with a greater emphasis on price stability adopted by Swedish governments since 1991.

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In the paper, we studied the implications of the adoption of the inflation targeting (IT) regime. We investigated whether there was empirical evidence for a regime switch (does the economic data show that a change in the institutional setting happened?) and whether this institutional switch has been associated with changes in the conduct of monetary policy (has it been tougher or smoother after the shift?), and in inflation and output processes (have they been more or less predictable?).

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Our results contribute to the literature in the following respect. First, they suggest that IT adoption has constituted a change in the monetary policy rule, but not in a way that has generally been admitted in the literature: the new regime which has been consecutive to IT adoption has less focused on inflation than during the pre-IT period. Lower and more stable inflation rates with a less aggressive central bank suggest a high level of credibility and a high potential to target other objectives than inflation.

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Second, a steep switch in the macroeconomic environment is also visible: this switch has been concomitant with a reduction of uncertainty precisely when IT has been adopted. Stated differently, economic variables have been more stable and more predictable after IT adoption. Drawing on an empirical assessment of the success of IT to anchor expectations in Sweden (Fregert and Jonung, 2008), the latter result suggests that the reduction in overall uncertainty pertaining to IT adoption may have depended on the high credibility of the new implemented regime through the increased transparency and communication of the Swedish central bank.

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Last, IT seems to offer some policy leeway: a counterfactual study approach suggests that central bank interest rate would have been higher had IT been adopted earlier. Contrary to some arguments in the literature, inflation targeters are not “inflation nutters”, having the obsession of curbing inflation, and the institutional setting that was been adopted in Sweden has improved the overall economic performance of the Swedish economy. Well, an example to follow?

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