Inflation targeting under inflation uncertainty - Multi-economy evidence from a stochastic volatility model

One of the most important advantages of an inflation target is that it helps to
reduce uncertainty about future inflation. However, this confidence may be undermined
if actual inflation continuously deviates from the target level. We examine
how inflation uncertainty relates to the presence of an inflation target and deviations
of inflation from the targeted level. Inflation uncertainty is quantified by
means of an Unobserved Components Stochastic Volatility model that allows to
distinguish between permanent and transitory inflation uncertainty. While longterm
inflation appears largely stable in most economies, the short-term inflation
uncertainty is found to be time-varying. Most notably, short-term inflation uncertainty
is high if inflation rates are below the target level. This is particularly
relevant for economies which are currently confronted with the presence of persistently
low inflation rates. Our findings suggest that announcing higher inflation
targets as it is currently discussed may be costly in terms of provoking higher
inflation uncertainty.