It is well known that, over the business cycle, most sectors of the economy move up and down together. This comovement is a central part of the definition of the business cycle. Under the National Bureau of Economic Research's (NBER) definition, for example, "a recession is a period of decline in total output, income, employment, and trade, usually lasting from six months to a year, and marked by widespread contractions in many sectors of the economy." More recently, Christiano and Fitzgerald (1998) document substantial business cycle comovement for hours worked across sectors in the US.
Over the last two decades, however, macroeconomists have mainly focused on understanding the persistence and volatility in the cyclical fluctuations of aggregate economic data. Standard models of business cycles such as Kydland and Prescott (1982) and King et al. (1988), consider a single sector economy to examine the ups and downs of aggregate economic activity. For the obvious reason, these models are not useful to explain a key defining characteristic of the business cycle: the comovement of economic activity across many sectors.
During a pilot project in Tanzania, financed by RUF under the Danish Ministry of Foreign Affairs, the Danish participants discovered that mercury-bearing soaps and creams manufactured in the United Kingdom were illegally smuggled into the country and sold on the markets in towns and villages. These products are claimed to be anti-septic, but the real purpose of using them is to obtain paler skin and hair.
On October 8, 1992, three weeks after sterling’s departure from the Exchange Rate Mechanism of the European Monetary System, the Chancellor of the Exchequer, Norman Lamont, established the first direct inflation target in the history of the United Kingdom, as a range of 1-4% for annual RPIX1 inflation. Since then, U.K. macroeconomic performance has been characterized by low and stable inflation, historically low interest rates, and, as of 2006 Q4, 56 quarters of uninterrupted output growth.
In previous research–see Benati (2004)–we used tests for multiple structural breaks at unknown points in the sample, and band-pass filtering techniques, to investigate changes in U.K. economic performance since the end of WWII. Empirical evidence suggests the inflation targeting regime to have been, in a very broad sense, significantly more stable than the previous post-WWII era. First, for both real GDP growth, and three alternative measures of inflation, we identified break dates around the time of the introduction of inflation targeting, in October 1992. For all four series, the estimated variance of reduced-form innovations over the most recent sub-period has been, so far, the lowest of the post-WWII era. Second, the volatility of the business-cycle components of macroeconomic indicators has been, after October 1992, almost always lower than either under Bretton Woods, or during the 1971-1992 period, often–as in the case of inflation and real GDP–markedly so.
