Does Inflation Targeting Anchor Long-Run Inflation Expectations? Evidence from Long-Term Bond Yields in the U.S., U.K. And Sweden
Federal Reserve Bank of San Francisco Working Paper No. 2006-09
51 Pages Posted: 22 Jul 2007
Date Written: March 2006
We investigate the extent to which inflation targeting helps anchor long-run inflation expectations by comparing the behavior of daily bond yield data in the United Kingdom and Sweden--both inflation targeters - to that in the United States, a non-inflation-targeter. 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 examine how much, if at all, far-ahead forward inflation compensation moves in response to macroeconomic data releases and monetary policy announcements. In the U.S., we find that forward inflation compensation exhibits highly significant responses to economic news. In the U.K., we find a level of sensitivity similar to that in the U.S. prior to the Bank of England gaining independence in 1997, but a striking absence of such sensitivity since the central bank became independent. In Sweden, we find that forward inflation compensation has been insensitive to economic news over the whole period for which we have data. Our findings support the view that a well-known and credible inflation target helps to anchor the private sector's perceptions of the distribution of long-run inflation outcomes.
Keywords: inflation targeting, inflation compensation, excess sensitivity, forward rates, high-frequency data
JEL Classification: E31, E52, E58
Suggested Citation: Suggested Citation
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By Magda Kandil