How can we measure the credibility of inflation targeting regimes?

Central bankers were once notoriously inscrutable: “If you understood what I just said, you must not have heard me correctly,” U.S. Federal Reserve Board Chair Alan Greenspan famously quipped. No more. Central banks now aim for clarity in their communications with the public. Nowhere is this change more apparent than in countries with inflation targeting regimes. Adoption of explicit targets for inflation compels central banks to monitor public and market opinion on whether their targets are credible. One issue the recent IMF conference on inflation targeting (see interview with Carol Carson, page 104) looked at was how central banks—inflation targeters in particular—try to measure credibility.

Abstract

Central bankers were once notoriously inscrutable: “If you understood what I just said, you must not have heard me correctly,” U.S. Federal Reserve Board Chair Alan Greenspan famously quipped. No more. Central banks now aim for clarity in their communications with the public. Nowhere is this change more apparent than in countries with inflation targeting regimes. Adoption of explicit targets for inflation compels central banks to monitor public and market opinion on whether their targets are credible. One issue the recent IMF conference on inflation targeting (see interview with Carol Carson, page 104) looked at was how central banks—inflation targeters in particular—try to measure credibility.

A dozen or so countries (see table below) have opted to combine a floating exchange rate with a monetary policy that seeks to achieve a publicly announced inflation goal. While the initial batch of inflation targeters were industrial countries, recent converts have tended to come from the ranks of emerging market countries. The operating procedures of many other central banks, such as that of the U.S. Federal Reserve, now have much in common with inflation targeters, even though these banks choose not to announce an explicit target for inflation.

Adoption of an explicit target compels central banks to maintain open lines of communication with the public and with markets. These central banks must explain the rationale for the target and the actions being taken to achieve it. And they must monitor whether their announced targets are “credible,” that is, whether the public has faith that the central banks will achieve their announced targets.

Who has adopted inflation targeting?

Since New Zealand adopted inflation targeting in July 1989, it has been joined by Canada (February 1991), United Kingdom (October 1992), Sweden (January 1993), Australia (April 1993), Czech Republic (December 1997), Poland (March 1999), Israel (June 1999), Brazil (June 1999), Chile (September 1999), South Africa (February 2000), Thailand (April 2000), Hungary (June 2000), Colombia (December 2000), Korea (December 2000), Iceland (March 2001), Norway (March 2001), and Mexico (June 2001). For additional information, see IMF Occasional Paper No. 202, Adopting Inflation Targeting: Practical Issues for Emerging Market Countries, by Andrea Schaechter, Mark R. Stone, and Mark Zelmer.

How are we doing?

Ed Koch, former mayor of New York City, was famous for seeking instant referendums on his job performance by stopping people on the streets of the city and asking them, “How am I doing?” Under an inflation targeting regime, central banks operate very much in the Ed Koch mode, always asking the public and the markets, “How are we doing?” If the central bank has announced that its inflation target is, say, 3 percent, but markets expect inflation to be 6 percent, the answer to the question is clearly: “Not very well.”

So how can central banks uncover market expectations of inflation and thereby gauge the credibility of the inflation targeting regime? Participants at the conference discussed a variety of possibilities. The simplest and most direct way is to use surveys of inflation expectations to see if there is a meeting of minds between the central bank and the public. When inflation targeting is first introduced, there may be significant differences between the central bank’s inflation targets (and forecasts) and the public’s expectations of inflation. But, as the IMF’s Edgar Ayales, Randall Merris, and Alfredo Torres explained, if the central bank starts to achieve its inflation targets, it begins to gain credibility; over time, this credibility will be reflected in a convergence of the central bank’s targets and the public’s forecasts of inflation.

Take Canada, which has targeted inflation for over a decade. The Bank of Canada’s Malcolm Knight noted that expected inflation in survey data has, over time, moved progressively closer to the midpoint of the Bank’s announced inflation target range. Moreover, the diversity of opinion across various forecasters on what inflation is likely to be has been diminishing. Both these features suggest, he said, that “the Bank of Canada has developed increasing credibility over the inflation-targeting period.” Inflation expectations are becoming “solidly anchored” on the midpoint of the target range for inflation announced by the Bank of Canada.

Indexed debt’s role

Another way to gauge credibility is through the issuance of indexed government debt—that is, government IOUs whose return is tied to the rate of inflation. The Bank of England’s Roger Clews explained how the difference between the return of indexed debt and the return on standard (nonindexed) debt provides a measure of inflation expectations. Imagine, he said, that a government issues a very simple bond promising to pay £100 in a certain number of years. Imagine that the government also issues another bond that pays off at the same time and pays £100 “uplifted by the ratio of the price level when it pays off to the price level now.”

The relative price of the two bonds “will clearly be closely connected to what people think the price level will be when the bonds pay out relative to now.” In other words, the difference in yields between the two bonds provides a measure of what the markets expect inflation to be. A comparison of this implicit measure of inflation expectations with the announced inflation target serves as a referendum on the credibility of the central bank’s policies.

How well have inflation targeters done by this metric? Clews presented evidence for the United Kingdom that once allowance is made for certain institutional features of U.K. prudential regulation, the implicit measure of inflation expectations is fairly close to the Bank of England’s inflation target. Likewise, the Bank of Israel’s Meir Sokoler noted that measures of inflation expectations derived from the country’s well-functioning indexed debt markets line up quite well with the Bank of Israel’s inflation target.

In the case of the United States, Vincent Reinhart of the U.S. Federal Reserve Board presented evidence that the difference between the yields on indexed and nonindexed debt has fallen from about percent in 1997 to about 2 percent today. While the U.S. Fed does not explicitly announce an inflation target, the narrowing of this differential suggests that the market expects the Fed to keep inflation at around 2 percent.

Paradox of success

Reinhart and other participants at the conference noted a “paradox of success” that can at times hamper, to some extent, the ability to uncover inflation expectations.As acentral bank becomes more successful in meeting its inflation target, its credibility with private markets rises. This has the paradoxical effect of making the private sector expend less energy and fewer resources on forecasting inflation: the central bank is going to achieve its inflation target, the private sector reckons, so why not just use the central bank target as the inflation forecast? Hence, an important independent check on the credibility of the central bank’s policies is lost. Canada’s Malcolm Knight noted in a similar vein that, as inflation becomes more predictable, the advantages of issuing indexed debt are reduced; over time, liquidity in the indexed debt market is reduced—”it can dry up”