DOES INFLATION TARGETING ANCHOR LONG-RUN INFLATION EXPECTATIONS? EVIDENCE FROM THE U.S., UK, AND SWEDEN⁴

Abstract

We investigate the extent to which inflation expectations have been more firmly anchored in the United Kingdom-a country with an explicit inflation target-than in the United States-a country with no such target-using the difference between far-ahead forward rates on nominal and inflation-indexed bonds as a measure of compensation for expected inflation and inflation risk at long horizons. We show that far-ahead forward inflation compensation in the U.S. exhibits substantial volatility, especially at low frequencies, and displays a highly significant degree of sensitivity to economic news. Similar patterns are evident in the UK prior to 1997, when the Bank of England was not independent, but have been strikingly absent since the Bank of England gained independence in 1997. Our findings are further supported by comparisons of dispersion in longer-run inflation expectations of professional forecasters and by evidence from Sweden, another inflation-targeting country with a relatively long history of inflation-indexed bonds. Our results support the view that an explicit and credible inflation target helps to anchor the private sector's views regarding the distribution of long-run inflation outcomes.

Macroeconomics and the Term Structure

“…A compelling example, is the market reaction to the announcement that the Bank of England was to be granted operational independence, on May 6, 1997. As documented by Gürkaynak, Levin, and Swanson (2010) and Wright (2011), U.K. nominal yields fell sharply, and the nominal yield curve flattened dramatically, on the very day of this announcement. Meanwhile, real yields were little changed.…”

The communication effects on inflation forecast errors: Empirical evidence from Colombia

“…A well-anchored inflation expectation in the inflation targets is fundamental to the central bank because it indicates the public confidence on monetary policy (Refet Gürkaynak, Andrew Levin, and Eric Swanson, 2010;Andrew Levin, 2014). Inflation forecast errors reflect disagreements among agents with regard to the monetary policy management.…”

“…The most popular market measurement used to estimate inflation expectations is Break-Even Inflation (BEI), also known as inflation compensation (Gürkaynak et al, 2010 andSöderlind, 2010). The BEI captures the compensation that investors demand both for expected inflation and for the risks or uncertainty associated.…”

The anchoring of inflation expectations in time and frequency domains

“…The empirical literature regarding the anchoring of inflation expectations is divided into two groups. The first strand of literature focuses on the news regression approach which is based on the idea that anchored inflation expectations should be insensitive to economic news (Beechey & Wright, 2009;G€ urkaynak, Levin, Marder & Swanson, 2007). The second strand of literature uses the pass-through criterion of Jochmann et al (2010) and Gefang et al (2012), which defines inflation expectations as anchored if longerterm expectations do not respond to changes in shorter-term expectations.…”

“…By examining the sensitivity of far-ahead forward inflation compensations to macroeconomic data releases and monetary policy announcements, they find that the degree of anchoring in the U.S. is weaker than that in Canada and Chile. Gurlaynak, Levin and Swanson (2010) compare the anchoring of inflation expectations in the United Kingdom (U.K.), Sweden, and the U.S. through similar methods. They find that, since 1997, when the Bank of England (BOE) became independent, inflation expectations have been better anchored than before with the responsiveness of inflation expectations to news strongly decreased.…”