Inflation targeting, flexible exchange rates and inflation convergence

Abstract

Using a disaggregated level Consumer Price Index (CPI) data, this article compares convergence properties of regional inflation rates in a small open economy, Turkey, between pre-inflation-targeting and inflation-targeting periods, where the latter also corresponds to a flexible exchange rate regime. It is found that during the inflation-targeting period, Turkish regional inflation rates have converged to each other in terms of CPI groups with relatively nontradable components, while they have diverged from each other in terms of CPI groups with relatively tradable components. Since a common and sound monetary policy among the regions of a country is supposed to have a convergence effect on regional inflation rates according to the conventional wisdom, the results for CPI groups with relatively tradable components require further attention and have significant policy implications, especially for inflation-targeting countries using flexible exchange rate regimes.

Keywords:

• inflation targeting
• inflation rate convergence
• regional analysis
• Turkey

JEL Classification:

• E31
• E50
• E52
• R12

Acknowledgements

The author thanks an anonymous referee, Mark Taylor and Carl Walsh for their helpful comments and suggestions. The usual disclaimer applies.

Notes

¹ See Gluschenko (2006), Busetti et al. (2006, 2007) and Ritola (2008), among many others, for analyses on the convergence of inflation rates.

² For the effects of inflation targeting on the economic performance of the adopting countries, see Mishkin (2002), Neumann and von Hagen (2002), Ball and Sheridan (2003), Goncalves and Salles (2008), and Goncalves and Carvalho (2009).

³ These results are available upon request.

⁴ The headline CPI inflation is used as a target in Turkey. See Ertugrul and Selcuk (2002) and Akay and Yilmazkuday (2008) for detailed analyses of the Turkish economy for the period 1980 to 2001. See Yilmazkuday (2007) for an analysis of the Turkish inflation targeting experience. See Berument (2003, 2007), Berument and Tasci (2004) and Yazgan and Yilmazkuday (2007) for different inflationary episodes and monetary policy specifications in Turkey. See Yazgan and Yilmazkuday (2005) for an analysis of the inflation dynamics of Turkey.

⁵ The modified gauss codes of Bai and Perron (1998, 2003) that are used in this article are available upon request.

⁶ It should be noted that the methodology of Pesaran (2007) allows to uncover the presence of ‘no divergence’ rather than convergence.

⁷ For all CPI categories, the significance of the intercept has been tested for each pair. Although the results show that the intercept is mostly insignificant at the 1% significance level, it is significant for up to 24% of pairs at the 10% significance level. Hence, to keep the analysis as general as possible, we kept the intercept in the ADF tests.

⁸ Note that the time between the financial crisis of February 2001 and the start of the explicit inflation targeting on January 2002 may also represent a possible lag for monetary policy transmission, since the structural break analysis suggests that the national rate of inflation had a break right after January 2002.

⁹ It is also important to note that the structural break tests estimate the very same break dates for national inflation rate (as in Table 2) and cross-sectional SD of Turkish regional inflation rates (as in Table 3) when the sample period is restricted to 1997:03 to 2004:12.