INFLATION, LEARNING AND MONETARY POLICY REGIMES IN THE G-7 ECONOMIES

Nicholas Ricketts and David Rose

Staff Working Papers from Bank of Canada

Abstract: In this paper, the authors report estimates of two- and three- state Markov switching models applied to inflation, measured using consumer price indexes, in the G-7 countries. They report tests that show that two-state models are preferred to simple one-state representations of the data, and argue that three-state representations are more satisfactory than two-state representations for some countries. The preferred estimation results usually include a state that features a unit root in its dynamic structure, which concurs with results of direct tests for this property. However, the multistate representation of the data shows that for all G7 countries these quasi-unit-root properties arise primarily from a few brief episodes of history, concentrated in the 1970s and associated with the major oil-price shocks. For all countries there is evidence of progress towards establishing credibility of regimes with stable inflation, and in many countries there is evidence of progress in building credibility of regimes with low inflation. Credibility refers to the ex post probability assigned to the state by the Markov model, which has a large effect on how expectations of future inflation are formed. An interesting contrast arises from the results for the United States and Canada. Whereas in Canada the credibility of a regime with historically low inflation has risen sharply in the last few years, in the United States there has been convergence on a regime with a stable, but historically average, rate of inflation and not on the alternative low-inflation regime. Dans cette etude, les auteurs presentent des estimations de modeles de Markov a changement de regime comportant deux et trois etats pour representer l'inflation, mesuree par les indices des prix a la consommation des pays du groupe des Sept. Les tests effectues revelent que les modeles a deux etats sont superieurs a ceux a etat unique et que, pour certains pays, les modeles a trois etats sont plus attrayants que ceux a deux etats. Les estimations retenues incorporent generalement un etat dont la structure dynamique est caracterisee par une racine unitaire compatible avec les resultats des tests directs de racine unitaire. Toutefois, les modeles a etats multiples indiquent que, pour tous les pays du groupe des Sept, cette propriete, de racine plutot quasi unitaire, resulte principalement de quelques evenements de courte duree, lies aux principaux chocs petroliers, qui sont surtout survenus dans les annees 70. Selon les resultats empiriques, tous les pays progressent vers l'etablissement de regimes credibles d'inflation stable, et de nombreux pays sont en voie d'implanter des regimes credibles de faible inflation. La notion de credibilite renvoie a la probabilite ex post que le modele de Markov attribue a l'etat, laquelle influe beaucoup sur la facon dont les anticipations d'inflation se forment. Un contraste interessant apparait lorsque les resultats obtenus pour les Etats-Unis a cet egard sont compares a ceux qui s'appliquent au Canada. Alors que, au Canada, la credibilite d'un regime de faible inflation s'est considerablement accrue au cours des dernieres annees, on a trouve aux Etats-Unis une convergence vers un regime caracterise par un taux d'inflation stable, mais de niveau habituellement moyen, plutot que le niveau bas du regime de faible inflation.

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