Is Inflation Bias Beneficial? Evidence from a Typical Discretionary - PDF document

Is Inflation Bias Beneficial? Evidence from a Typical Discretionary Monetary Policy Strategy Zafar Hayat* Abstract A discretionary central banker accepts excess inflation (inflation bias) either to stabilize real growth or spur it beyond the natural rate of economy. The paper posits that empirical investigation of the extent of effectiveness of inflation bias per se in achieving these objectives is important in (i) defining the scope of monetary policy as an inflation and growth-stabilizer and (ii) assessing if discretion should be preferred over commitment for achievement of such dual objectives. Since, no inflation bias indicators exist to carry out appropriate empirical analysis, this paper proposes a framework to generate new inflation bias indicators for a typical example of the discretionary monetary policy strategy of Pakistan. Autoregressive distributed lag (ARDL) bounds testing and estimation strategy is used not only to account for optimal dynamics but to avoid spurious regression and endogeneity problems. The findings of the paper, based on stable and robust results suggest that inflation- stabilization should be the prime objective of monetary policy. To avoid long-term real growth losses, a commitment based monetary policy should be preferred to discretion as the latter produces inflation bias, which is significantly detrimental to real growth in the long-run. Jel Code: E52, E58, E5,E32, C32, E31 Keywords: Inflation Bias, Discretion, ARDL, Pakistan * School of Economics and Finance, Massey University, New Zealand. Email: z.hayat@massey.ac.nz. Funded by Higher Education Commission (HEC) of Pakistan. 1

1. Introduction There is a consensus that vesting unconstrained discretion with central bankers to achieve twofold objectives of inflation and growth leads to excess inflation (inflation bias). Such a central banker is tempted to compromise on inflation objective by accommodating excess inflation to spur growth beyond its potential (Kydland and Prescott, 1977; Barro and Gordon, 1983). As a remedy, to contain this temptation and the resultant inflation bias, several countries either evolved mechanisms to overcome the time inconsistency problem (Berleman, 2005) or adopted commitment- based monetary policy frameworks (inflation targeting). Inflation targeting countries performed markedly well in achieving their prime objective of price stability. 1 Steady long-term growth, under this framework is deemed to be the by-product of low and stable inflation (Dotsey, 2008). The growth performance of inflation targeting countries is also commendable (Concalves and Salles, 2008 and Roger, 2010) as this framework allows sufficient flexibility for short-run growth- stabilization (Haldane, 1995 and Debelle, 1998). It is quite puzzling that despite high and volatile inflation, several emerging market countries such as Pakistan has adhered to discretion (illustrated in section 2) instead of adopting inflation targeting. 2 One of the potential reasons of strict adherence to the discretionary monetary policy strategies, in general, is the consideration either for growth-stabilization or the ambition for attainment of high growth rates. For example, some of studies such as Ball and Sheridan (2005), Brito and Bystedt (2010) 1 See for example, Haldane (1995); Bernanke et al. (1999); Cecchetti and Ehrmann, (1999); Corbo et al. (2001); Neumann and Von Hagen, (2002); Levin et al. (2004); Peturson (2005); Vega and Winkelried (2005); Batini and Laxton, (2006); Lin and Ye (2009); Roger (2010) and Brito and Bystedt (2010). 2 In Pakistan, the average inflation from 1971 to 2010 is 9.39% , and inflation volatility, as measured by variance, is 29.98%. 2

and Chowdhry and Islam (2011) are sceptical of the output performance of inflation targeting countries. Similarly, in case of Pakistan, Chaudhry and Chowdhry (2006), Akbari and Rankaduwa (2006), Felipe (2009) and Naqvi and Rizvi (2010) argue against the adoption of inflation targeting, largely on the basis that it may negatively affect growth. This growth-scepticism against inflation targeting is predominantly motivated by the implicit assumption of a positive relationship between inflation and growth. However, the relationship between inflation and growth is far from straightforward. For example, up till the mid 1970s, the Phillips curve (positive relationship between inflation and growth) was popular, while the empirical evidence in the 1990s suggests a negative relationship (see for example, De Gregario, 1992-93; Barro, 1995 and Ireland, 1999). One of the aspect of empirical evidence, in the 1990s and 2000s suggest a nonlinear relationship between inflation and growth (see for example, Fischer, 1993; Sarel, 1996 and Khan and Senhadji, 2001). Its implications for the findings of the previous empirical research are rather serious. It means that previous studies either overestimated or underestimated the effects of inflation on growth. Divergence in long and short-term effects of inflation on real growth is yet another dimension. For example, in the long-term inflation is believed to be negatively affecting growth, however, in the short-run monetary policy can be used to stabilize growth, which suggests a short-term positive relationship between the two. Despite all this complexity about the relationship of inflation and growth amidst variety in evidence and viewpoints, there exists one common point of agreement. The economists, irrespective of whether they are proponents of discretion or commitment, agree that an unknown but a certain low and steady rate of inflation is crucial for real growth. This implies that the core contention between them is the 3

excess inflation per se – the inflation exceeding that unknown but low and steady rate. This excess inflation in the literature has been termed as inflation bias. The pervasive explanation for inflation bias is the central banker‘s exercise of its discretion in pursuit of twofold objectives of inflation and growth, specifically, its temptation to raise the latter beyond its potential (Kydland and Prescott, 1977; Barro and Gordon, 1983). The role of such a discretionary central banker vis-a-vis a central banker with commitment is more challenging. The former has both inflation and growth- stabilization objectives, whereas the latter primarily stabilizes inflation. A discretionary central banker accepts inflation bias to stabilize growth, however, the extent of the effectiveness of inflation bias per se in achieving this objective, is yet to be empirically investigated. This is particularly important: first, in defining the scope of the role of monetary policy in stabilizing inflation or growth and second, in assessing if discretion should be preferred over commitment for the achievement of the dual objectives of inflation and growth-stabilization. For this purpose, this paper proposes a framework to generate inflation bias indicators for Pakistan. These indicators are generated using the benchmark optimal, desirable and threshold inflation-growth nexus rates. These benchmarks are estimated from a dynamically stable baseline growth model. Long and short-term parameters of the proposed indicators are then estimated from the baseline growth model. Autoregressive distributed lag (ARDL) bounds testing and estimation approach of Pesaran et al. (2001) is used to avoid spurious regression and endogeneity problems. Consistent with the theory of commitment against discretion, the results show that all the indicators of inflation bias affect the real growth adversely in the long-run. 4

Nevertheless, there is an evidence of a short-term real growth gain from inflation bias due to its positive effect on the real growth. These relationships are robust for all the generated inflation bias indicators. This evidence essentially reflects a trade-off between a long-term growth-loss and a short-term-growth gain. Since, the magnitude of the long-term negative effect of inflation bias on real growth is greater than its short-term positive impact, the policy suggestions are as follows. Firstly, these findings proposes that inflation-stabilization should be the prime and the long-term objective of monetary policy and growth stabilization be a short-term objective. Secondly, to avoid long-term real growth losses, commitment based monetary policy should be preferred to discretion as the latter produces long-term inflation bias, which is significantly detrimental to real growth. The remainder of the paper is organized as follows. Section 2 briefly reviews the literature to highlight the issue of the synonymous treatment of inflation and inflation bias in the empirical literature. It also discusses the unique features of Pakistan‘s monetary policy that are typical to discretion. Further, the distinction among the optimal, desirable and threshold inflation rates is brought out in this section. Section 3 proposes the methodological framework for estimation of benchmark inflation- growth nexus rates and inflation bias indicators. This section also specifies the models, discusses the estimation strategy and the data. Section 4 analyses the long- term relationships between the real growth and the proposed inflation bias indicators and reports the stationarity properties of the variables. Section 5 presents and analyses the results and conduct the robustness checks while Section 6 concludes the paper. 5