Inflation targeting: A time-frequency causal investigation

Area of Science:

• Macroeconomics
• Monetary Policy Analysis
• Developing Economies

Background:

• The effectiveness of interest rate policy in developing economies is debated, with structural and supply-side factors playing a key role.
• Existing literature does not definitively establish causality between inflation and interest rates.
• Central banks in developing nations widely adopt interest rate policies, prompting an investigation into their motivations.

Purpose of the Study:

• To investigate the causal relationship between interest rates and inflation across various time and frequency scales in developing economies.
• To extend the understanding of causality in monetary policy beyond traditional short- and long-run analyses.
• To uncover the dynamics driving central bank policy in the face of inflation in developing nations.

Main Methods:

• Wavelet transformation applied to monthly interest rate and inflation data for 22 developing economies (1992-2022).
• Analysis across a spectrum of frequency scales to explore causality beyond conventional timescales.
• Examination of the intricate causal interplay between key macroeconomic variables.

Main Results:

• A positive causal link was found between policy interest rates and inflation in developing economies.
• Increases in central bank interest rates were associated with subsequent price level surges.
• A paradoxical cycle emerges where central banks raise rates in response to inflation, potentially exacerbating it.

Conclusions:

• Traditional monetary policy of raising interest rates to curb inflation may be counterproductive in developing economies.
• Structural and supply-side factors are critical for breaking the observed positive causality cycle.
• Central banks need to re-evaluate strategies and focus on underlying economic determinants to manage inflation effectively.