FRBSF Economic Letter
2006-20; August 11, 2006
Would an Inflation Target Help Anchor U.S. Inflation Expectations?
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Particularly now that we are in the general range of price
stability, I believe that quantifying what the FOMC means
by price stability would provide useful information to the
public
and lend additional clarity to the policymaking process…
Although communication plays several important roles in inflation
targeting, perhaps the most important is focusing and anchoring
expectations.
—Ben Bernanke (2003)
Since the October 2005 nomination of Ben Bernanke to become
Chairman of the Federal Reserve Board, there has been increasing
speculation
in the financial press that the Federal Open Market Committee
(FOMC) might soon adopt an explicit numerical objective for
inflation. However, skeptics of inflation targeting have maintained
that
this would constrain the FOMC and might provide little benefit
in return—after all, it has been argued, haven't inflation
expectations in the U.S. been well anchored since the early to
mid-1990s?
In this Economic Letter, I discuss recent research on whether
inflation expectations in the U.S. have been well anchored
over this period and whether an explicit numerical objective
for inflation
might help to "focus and anchor" those expectations.
These are important questions which we have only recently begun
to be able to answer using high-frequency financial market data
from a variety of countries.
Using inflation compensation to assess anchoring of expectations
Many countries, including the U.S., have issued government-backed
bonds that are indexed for inflation. The yield spread between
nominal government bonds and inflation-indexed government bonds
then represents the return that investors require as compensation
for expected inflation and inflation risks over the lifetime
of the bonds. For example, if the yield on a 10-year nominal
U.S. Treasury note is 5% and the yield on a 10-year inflation-indexed
Treasury note is 2%, then investors are implicitly demanding
a 3% premium to hold the nominal security in order to compensate
them for expected inflation and the risks of unexpected inflation
over the 10-year lifetime of the bonds. This yield spread,
which we will call "inflation compensation," then provides
a publicly observable and very timely measure of financial market
concerns about inflation.
To investigate the anchoring of inflation expectations, then,
it is natural to examine the behavior of inflation compensation.
For example, we might start by comparing the daily volatility
of long-term inflation compensation in the U.S. to that in
some other country which has an explicit numerical inflation
target,
such as the U.K. From January 1997 to June 2006, the period
for which inflation-indexed bond data for the U.S. are available,
this comparison does indeed suggest that long-term inflation
compensation in the U.S. has been more volatile than in the
U.K.—the
standard deviation of daily changes in 10-year inflation compensation
in the U.S. over this period was about 4.34 basis points, compared
to 3.50 basis points in the U.K., implying that long-term inflation
compensation in the U.S. was about 25% more volatile than in
the U.K.
There are problems with this first-pass comparison, however,
because inflation compensation can sometimes fluctuate for
reasons other than changes in market concerns about future inflation.
For example, low liquidity in the inflation-indexed bond market
can cause those securities to trade at a discount relative
to
their fundamental value and can cause indexed bond prices to
fluctuate more in response to large, idiosyncratic trades.
Moreover, the amount of liquidity and the price premium attached
to liquidity
in the U.S. and U.K. markets are likely to differ across the
two countries and may also vary over time. As a result of these
types of confounding factors, it is not clear that the daily
volatility of inflation compensation is really very informative
about whether inflation expectations in the U.S. or U.K. are
well anchored or not.
Fortunately, we can work around these difficulties by focusing
attention on systematic changes in inflation compensation,
as proposed by Gürkaynak, Sack, and Swanson (2003, 2005). Their
essential insight is the following. If investors had very firm
expectations about what inflation would be in the long run and
had a high degree of confidence in those expectations, then a
one-off surprise in the CPI today should not cause them to revise
their views about the long-term inflation outlook going forward.
By contrast, if investors' long-term inflation expectations were
not perfectly anchored, then they might expect some partial pass-through
(or some risk of such pass-through) from near-term inflation
to the long-term inflation outlook. For example, a surprisingly
high CPI number released today might, in the case of unanchored
inflation expectations, cause investors to revise upward somewhat
their concerns regarding the long-term inflation outlook.
This systematic relationship suggests a formal econometric
test for whether inflation expectations in a given country are
well
anchored or not. If we know the dates of major economic data
releases, then we can test whether changes in long-term inflation
compensation on those dates have any systematic relationship
to the data releases themselves. Put simply, does a surprisingly
high CPI announcement have any systematic effect on long-term
inflation compensation in a given country, or not?
Gürkaynak, Sack, and Swanson (2003, 2005) perform essentially
this test, with a few additional technical refinements that improve
the test's power. For example, the authors analyze both nominal
interest rates and inflation compensation, because the former
is available for a longer sample than the latter for the U.S.
and because both series should be insensitive to economic news
at long enough horizons under standard assumptions. Also, they
are careful to focus on the surprise component of economic announcements
rather than on the announcements themselves, because bond markets
should not respond to the component of economic announcements
that are already expected.
Are inflation expectations in the U.S. well anchored?
Gürkaynak, Sack, and Swanson (2003, 2005) apply the above
test to the U.S. and find that, in fact, long-term interest rates
and inflation compensation in the U.S. have varied quite systematically
in response to economic news. In other words, long-term inflation
expectations in the U.S. do not appear to be completely anchored,
at least not over the 1990-2002, 1994-2002, or 1998-2002 samples
that they consider. As the intuition above would suggest, long-term
interest rates and inflation compensation in the U.S. rise in
response to higher-than-expected inflation announcements and
fall in response to lower-than-expected announcements. The authors
also find that positive surprises in GDP and employment, for
example, cause long-term interest rates and inflation compensation
to rise as well, consistent with the idea that a robust economy
puts upward pressure on prices and that bond markets in turn
become concerned that some of this pressure will pass through
to long-term inflation. Finally, and most interestingly, they
document an inverse relationship between long-term inflation
compensation and surprises in the federal funds rate, so that
surprise monetary policy tightenings by the Fed typically cause
long-term inflation compensation to fall in response. In other
words, bond markets appear to have interpreted monetary policy
tightenings in the 1990s as indicative of greater Fed resolve
to keep inflation low in the future and relaxed their concerns
about the long-term inflation outlook in response.
To be sure, the magnitude of the sensitivity of long-term inflation
compensation that Gürkaynak, Sack, and Swanson estimate
is not large, amounting to changes of just a few basis points
per standard deviation surprise in an economic announcement.
(It would indeed be quite a problem if long-term interest rates
gyrated wildly in response to every economic news release!) Nonetheless,
the magnitudes of these responses are almost as large as the
magnitudes of short-term interest rate responses to these economic
announcements, suggesting that there is a substantial degree
of pass-through from short-term inflation to bond market concerns
about the long-term inflation outlook. Thus, from this perspective,
long-term inflation expectations in the U.S. do not appear to
have been particularly well anchored, even since the mid-1990s.
Are inflation expectations in other countries better anchored?
Even if long-term inflation expectations in the U.S. are not
perfectly anchored, are there any countries in which inflation
expectations are better anchored? Perhaps surprisingly, the
answer appears to be yes—there are several such countries.
Gürkaynak, Levin, and Swanson (2006) and Gürkaynak,
Levin, Marder, and Swanson (2006) extend the analysis described
above for the U.S. through the end of 2005 and apply it also
to the U.K., Sweden, and Canada. Besides being highly industrialized,
the U.K., Sweden, and Canada provide natural comparisons to the
U.S. for two reasons: first, all three countries have issued
inflation-indexed debt since at least the mid-1990s, which allows
us to compare the behavior of inflation compensation across countries;
and second, all three nations have had an explicit numerical
objective for inflation over this same period, providing us with
a natural experiment that contrasts with the U.S.
The striking finding of these studies is that, in contrast
to the U.S., long-term inflation compensation in the U.K., Sweden,
and Canada does not respond systematically to economic news
over
this period. A natural interpretation of this finding is that
the presence of an explicit numerical inflation objective has
indeed helped to "focus and anchor" private sector
and financial market inflation expectations in these countries.
Since there is no reason to think that financial markets in the
U.K., Sweden, and Canada are fundamentally different from those
in the U.S., the experience of these countries provides support
for the view that an explicit numerical inflation objective would
improve the anchoring of long-term inflation expectations in
the U.S.
Summary and conclusions
Recent research using high-frequency financial market data
suggests that inflation expectations in the U.S., even since
the mid-1990s,
have not been as well anchored as in some other countries.
Long-term U.S. interest rates and inflation compensation have
responded
systematically to economic news in a way that suggests financial
markets see some pass-through (or some risk of pass-through)
from short-term inflation to the long-term inflation outlook.
In contrast to the U.S., several countries with explicit long-run
inflation objectives seem to have achieved a better anchoring
of long-term inflation expectations over this period.
These findings are exciting. They suggest that, despite the
generally superb performance of the U.S. economy and U.S. monetary
policy
over the past 15 years, there is still potential for improvement.
A better anchoring of inflation expectations in the U.S. could
have many benefits, such as more stable and lower long-term
interest rates, which would increase the ability of firms to
make efficient
investment decisions, and more stable and predictable inflation,
which would improve the efficiency of firms' pricing decisions.
Although there is no guarantee that the U.S. would realize
large gains in these areas, these efficiency improvements would
nonetheless
help to allocate workers to firms with the best long-term prospects
and lead to a more productive and stable U.S. economy. Eric Swanson
Research Advisor
References
[URLs accessed August 2006.]
Bernanke, Ben. 2003. "A Perspective on Inflation Targeting." Speech
at the Annual Washington Policy Conference of the National
Association of Business Economists. Washington, DC. March 25,
2003.
Gürkaynak, Refet, Andrew Levin, Andrew Marder, and Eric
Swanson. 2006. "Inflation Targeting and the Anchoring of
Long-Run Inflation Expectations in the Western Hemisphere." Forthcoming
in Series on Central Banking, Analysis and Economic Policies
X: Monetary Policy under Inflation Targeting, eds. Frederic
Mishkin and Klaus Schmidt-Hebbel. Santiago, Chile: Banco
Central de Chile.
Gürkaynak, Refet, Andrew Levin, and Eric Swanson. 2006. "Does
Inflation Targeting Anchor Long-Run Inflation Expectations? Evidence
from Long-Term Bond Yields in the U.S., U.K., and Sweden." FRBSF
Working Paper 2006-09.
Gürkaynak, Refet, Brian Sack, and Eric Swanson. 2003. "The
Excess Sensitivity of Long-Term Interest Rates: Evidence and
Implications for Macroeconomic Models." Federal
Reserve Board Finance and Economics Discussion Series 2003-50.
Gürkaynak, Refet, Brian Sack, and Eric Swanson. 2005. "The
Sensitivity of Long-Term Interest Rates to Economic News: Evidence
and Implications for Macroeconomic Models." American
Economic Review 95(1), pp. 425-436.
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do not necessarily reflect the views of the management
of the Federal Reserve Bank of San Francisco or of the
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