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Monday, April 09, 2007

Explicit Inflation Targets and Anchored Expectations

The Fed has been discussing whether to adopt an explicit inflation target, something Ben Bernanke favors, and this has brought about an active debate within the Fed and elsewhere about the virtues of inflation targeting generally, and explicit inflation targeting in particular. With explicit inflation targeting the central bank announces a target inflation range, the measure of inflation it will use to assess price pressures, how much time it will allow to bring inflation within the target range, and so on. As noted, presently the U.S. does not announce its target, but many other central banks do.

One argument for explicit inflation targeting is that it helps to anchor inflation expectations, more so than with an implicit target like the U.S. uses. However, Alan Greenspan and others argue that there is also a cost to committing to an inflation target, loss of flexibility when large unexpected events hit the economy. Since the Fed has been able to control inflation without an explicit target, they argue there is little to be gained in terms of anchoring expectations from moving to explicit targets.

There are two responses to this. First, as Bernanke and others have argued, flexibility can be built into a targeting regime so the costs are not as large as claimed.

But what about the benefits? The second response is that the benefits may not be as small as many have argued. This paper exploits cross-countries differences in whether inflation targets are explicitly announced to examine whether explicit targets lead to more firmly anchored inflation expectations. The paper finds evidence that explicit inflation targeting does help to to anchor expectations, i.e. that there are benefits to announcing a target, even for a country like the U.S. with a strong and credible inflation fighting record over the last few decades:

Inflation Targeting and the Anchoring of Inflation Expectations in the Western Hemisphere, by Refet S. Gürkaynak, Andrew T. Levin, Andrew N. Marder, and Eric T. Swanson, FRBSF Economic Review 2007: [This article is reprinted from the conference volume Series on Central Banking, Analysis, and Economic Policies X: Monetary Policy under Inflation Targeting, eds. Frederic Mishkin and Klaus Schmidt-Hebbel. Santiago, Chile: Central Bank of Chile, 2007.]  Abstract We investigate the extent to which long-run inflation expectations are well anchored in three Western Hemisphere countries—Canada, Chile, and the United States—using a high-frequency event-study analysis. Specifically, we use daily data on far-ahead forward inflation compensation—the difference between forward rates on nominal and inflation-indexed bonds—as an indicator of financial market perceptions of inflation risk and the expected level of inflation at long horizons. For the United States, we find that far-ahead forward inflation compensation has reacted significantly to macroeconomic data releases, suggesting that long-run inflation expectations have not been completely anchored. In contrast, the Canadian inflation compensation data have exhibited significantly less sensitivity to Canadian and U.S. macroeconomic news, suggesting that inflation targeting in Canada has helped to anchor long-run inflation expectations in that country. Finally, while the requisite data for Chile are available for only a limited sample period (2002–2005), our results are consistent with the hypothesis that inflation targeting in Chile has helped anchor long-run inflation expectations in that country as well.

1. Introduction Many central banks have adopted a formal inflation-targeting framework based on the belief and the theoretical predictions that an explicit and clearly communicated numerical objective for the level of inflation over a specified period would, in itself, be a strong communication device that would help anchor long-term inflation expectations.[1] Empirically verifying the success of inflation-targeting regimes in this dimension has been difficult, however, as survey data on long-term inflation expectations tend to be of limited availability and low frequency.[2]

In this paper, we use daily bond yield data for Canada, Chile, and the United States to investigate whether long-term inflation expectations in these countries are anchored, essentially extending the analysis of Gürkaynak, Sack, and Swanson (2005) and Gürkaynak, Levin, and Swanson (2006) to examine comparable data for Canada and Chile. Of these three countries, Canada and Chile have been formal inflation targeters throughout much of the 1990s and 2000s, while the United States has not had an explicit numerical inflation objective. We test the success of inflation targeting in anchoring long-term inflation expectations by comparing the behavior of long-term nominal and indexed bond yields across these three countries in response to important economic developments. Forward inflation compensation—defined as the difference between forward rates on nominal and inflation-indexed bonds—provides us with a high-frequency measure of the compensation that investors require to cover the expected level of inflation, as well as the risks associated with inflation, at a given horizon. If far-ahead forward inflation compensation is relatively insensitive to incoming economic news, then one could reasonably infer that financial market participants have fairly stable views regarding the distribution of long-term inflation outcomes. This is precisely the outcome one would hope to observe in the presence of an explicit and credible inflation target.

The daily frequency of our bond yield data, together with the frequent release of important macroeconomic statistics and monetary policy announcements, provides a large event-study data set for our analysis. This holds even for samples that span only a few years—the period for which we have inflation-indexed bond data for the United States and long-term nominal bond data for Chile. Thus, in contrast to previous empirical work using quarterly or even semiannual data, we are able to bring to bear thousands of daily observations of the response of long-term bond yields to major economic news releases in Canada, Chile, and the United States.

For the United States, we find that far-ahead forward nominal interest rates and inflation compensation have responded significantly and systematically to a wide variety of macroeconomic data releases and monetary policy announcements.

These responses are all consistent with a model in which the private sector’s view of the central bank’s long-run inflation objective is not strongly anchored, as we show. In Canada, far-ahead forward nominal interest rates and inflation compensation have displayed much less sensitivity to either domestic or foreign economic news. Thus, the anchoring of long-run inflation expectations in Canada appears to have been stronger than in the United States. Finally, the data for Chile are more limited in terms of the sample period, the depth and breadth of fixed income markets, and the availability of domestic macroeconomic data releases. Despite these limitations, we do not find significant responses of far-ahead inflation compensation in Chile with respect to domestic or foreign macroeconomic news.3


6. Conclusions As in Gürkaynak, Sack, and Swanson (2005) and Gürkaynak, Levin, and Swanson (2006), we find that U.S. longterm nominal interest rates and inflation compensation are excessively sensitive to macroeconomic data releases and monetary policy announcements. In contrast, we find that long-term nominal interest rates and inflation compensation in Canada display much less sensitivity to economic news, while the unconditional volatility of these series over the past decade has been markedly lower than in the United States. These results are consistent with the findings of Gürkaynak, Levin, and Swanson (2006) for Sweden and the United Kingdom, two countries that have also maintained explicit inflation targets in recent years.

In the case of Chile, the available sample period is fairly short and only a limited set of macroeconomic news releases are readily available. Nevertheless, our regression analysis does not indicate any excess sensitivity of far-ahead forward interest rates and inflation compensation, which is consistent with the hypothesis that inflation targeting in Chile has been reasonably successful in anchoring long-run inflation expectations. ... While not entirely conclusive, these results suggest that the presence of a transparent and credible inflation objective can play an important role in anchoring long-run inflation expectations in both emerging market economies and industrialized countries.

Our findings suggest that the potential welfare gains from reduced bond market volatility would be an important subject for future research. Although we have not demonstrated any such welfare gains in this paper, existing macroeconomic and finance theory identifies several possibilities: for example, less persistent deviations of inflation from target in the short and medium run as a result of firmer anchoring of expectations at the long end (Woodford 2003); a greater ability of the central bank to control inflation in the short and medium run (Woodford 2003); less volatile long-term nominal interest rates and lower risk premiums on nominal rates, which would improve the efficiency of investment decisions (Ingersoll and Ross 1992); and a reduced chance of either a 1970s-style expectations trap for inflation (Albanesi, Chari, and Christiano 2003) or an imperfect-information-driven inflation scare (Orphanides and Williams 2005). To the extent that these benefits are important in practice as well as in principle, adopting a more explicit inflation objective could improve U.S. economic performance and U.S. monetary policy even beyond the successes of the past 20 years.

1. See, for example, Leiderman and Svensson (1995), Bernanke and Mishkin (1997), Svensson (1997), and Bernanke et al. (1999).

2. For an analysis using semiannual survey data on long-run inflation expectations in the 1990s and early 2000s for a panel of countries, see Levin and Piger (2004).

3. Ertürk and Özlale (2005) obtain a similar finding of anchored expectations for Chile using a GARCH specification on monthly Chilean data.

This won't settle the issue, but it does add to the weight of evidence in favor of explicit inflation targets. For more on inflation targeting, see David Altig at macroblog who discusses whether U.S. expectations are presently losing their anchor.

    Posted by on Monday, April 9, 2007 at 02:07 PM in Academic Papers, Economics, Inflation, Monetary Policy | Permalink  TrackBack (0)  Comments (2)


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