RDP 2002-01: Inflation Targeting and the Inflation Process: Some Lessons from an Open Economy 5. Conclusion

Whether an open economy should target aggregate or non-traded inflation depends on the objective function of the policy-maker, the nature of the shocks that the economy is exposed to, and the structural relationships in the economy. In the end, the answer to this question is an empirical issue. The results in this paper suggest that, for the Australian economy, the choice of inflation target does not generally make much difference to the extent of inflation or output variability. In part, this appears to be because the estimated pass-through of exchange rate changes to aggregate inflation is protracted.

Changes in the structure of the economy, and particularly the inflation process, however, will affect this conclusion. The paper has also shown that there have been quite significant changes in the inflation process over the past two decades. Most notably, the effect of exchange rate changes on inflation has become more muted. The inflation process overall also appears to have become considerably better anchored. Both of these developments would tend to provide further support for the above conclusion and imply that the Australian economy has become more resilient to temporary price level shocks.

Evidence from other countries, however, suggests a need for caution. There is considerable variation in the inflation process both across countries and over time, in ways that seem difficult to explain. It is possible, in particular, that the response of the economy to specific shocks may vary from the average responses implied by reduced-form regression analysis, because of changing perceptions about the nature and likely permanence of shocks. Because such changes can have significant effects on inflation and growth outcomes, policy-makers will always need to be mindful of this fact, and exercise judgement and flexibility in assessing the economic outlook.