Disentangling the Predictive Power of Term Spreads under Inflation Targeting

Abstract

Under inflation targeting, S. Cho and J. Lee (2014, Inflation targeting and predictive power of term spreads. Seoul Journal of Economics, 27, 391-419), A. Estrella (2005, Why does the yield curve predict output and inflation? The Economic Journal, 115, 722-744) and P.L. Siklos (2000, Inflation targets and the yield curve: New Zealand and Australia versus the US. International Journal of Finance & Economics, 5,[15][16][17][18][19][20][21][22][23][24][25][26][27][28][29][30][31][32] have reported that the predictive power of yield spreads for future inflation decreases in inflation targeting countries. In this paper, we decompose the yield spread into the expectations hypothesis component and the term premium, and find that the decrease in the predictability is mostly due to the deterioration of information embedded in the expectations hypothesis component. Our finding reveals that if inflation targeting is successful in achieving its main goal, then the expectations for future inflation are anchored at the target inflation rate (or range), and thereby the predictive contents of the term spreads regarding future inflation decrease.