Inflation Targeting Macroeconomic Distortions and the Policy Reaction Function

The paper examines the evolution of monetary policy design in Australia over the past quarter of a century culminating recently in the adoption of an inflation targeting approach through the institutional mechanism of CBI (Central Bank Independence). Cross-country empirics have repeatedly confirmed the stylized fact that high CBI delivers low inflation. This study covers new ground by using time-series techniques to test the nexus between CBI and inflation using Australian quarterly time-series data for the sample period 1973Q3-1998Q4. The theoretical analysis based on a quadratic social loss function subject to a Lucas supply curve demonstrates that the exclusive focus on the institutional mechanism of CBI to reduce inflation bias may be flawed because it ignores the spillover effects of macroeconomic distortions on inflation. Time-series composite indices were constructed to proxy CBI and macroeconomic distortions in the labour market, the tax system and in the arena of international competition. The general-to-specific methodology was applied to sequentially derive a parsimonious VECM (Vector Error Correction Model) linking CBI and macroeconomic distortions to inflation during the study period. Granger causality tests indicated that both CBI and macroeconomic distortions Granger caused inflation. The VECM empirics revealed that CBI and neocorporatism contributed in a significant manner to reduction of inflation during the study period. The fact that neocorporatism curbed inflation during the study period raises the issue that the industrial relations reforms agenda aimed at eroding neocorporatism are politically motivated and lack an economic rationale. However, when the link between inflation and neocorporatism was reanalyzed taking feedback effects into account using the VAR methodology a different picture emerged. The impulse response functions revealed that an increase in neocorporatism exacerbated inflation in the short run. Thus the VAR empirics therefore provided a rationale for the labour market reforms aimed at rectifying labour market distortion attributed to neocorporatism. Both the VECM and VAR empirics make a strong case for tax reform in order to reduce welfare payments without compromising on safety net and equity issues. It also makes a case for reducing the volatility or the real exchange rate to sharpen Australia's competitive edge. The significance of macroeconomic distortions in causing output to deviate from potential underscore that the policy reaction function is influenced by distortions. Non-nested tests revealed that the Taylor rule taking account of deviations of output from potential due to macro distortions was superior to an inflation rate only rule. Therefore the study results recommend that policymaker (Reserve Bank of Australia) should pursue a Taylor rule rather than inflation rate only rule in smoothing the overnight cash rate to achieve the pre-announced inflation target.