Inflation Persistence, Monetary Regimes and Credibility: A Long-term Perspective

Abstract

Inflation persistence or ‘inertia’ has important consequences for monetary policy. Inflation which does not get eliminated today tends to persist entailing higher costs in the future. In turn, a monetary regime can exert significant influence on inflation persistence by its credibility and responses in the face of inflationary shocks. In this study, we use a flexible, time-varying parameter approach to analyze inflation persistence in the United Kingdom and United States during 1880-2016. Our results indicate strong evidence for time-varying inflation persistence in conjunction with shifts in monetary policy regimes. Further, we show that credibility of the monetary regime significantly influences inflation persistence observed under the regime, such that higher (lower) regime credibility leads to lower (higher) inflation persistence. Finally, we argue that institutional framework such as adherence to a rule-based policy, provision of a nominal anchor, policy autonomy etc., and the actions of monetary authorities are vital for understanding the shifts in regime credibility and inflation persistence across time. Overall, our findings indicate that appropriate design and credible conduct of monetary policy is crucial for achieving and sustaining price stability.