FRBSF Economic Letter
2006-22; September 1, 2006
Inflation Targets and Inflation Expectations: Some Evidence
from the Recent Oil Shocks
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A great deal of recent research has pointed out
the benefits of adopting inflation targets, emphasizing, in particular,
their role in helping to stabilize inflation expectations. As
we discuss below, these arguments suggest that inflation expectations
in countries that target inflation should react differently to
the recent oil price shocks than expectations in countries that
do not target inflation. We examine whether this is indeed the
case by comparing the recent behavior of inflation expectations
in the U.S.—which does not have an explicit inflation target—with
the behavior of inflation expectations in Canada and the U.K.,
which do.
Recent research and some data
Proponents of inflation targeting have argued
that it will decrease inflation variability, reduce the inflationary
impact of shocks to the economy and anchor inflation expectations.
For example, Mishkin (2004, p. 120) claims that the U.S. would
benefit from adopting an inflation target in a number of ways: "First,
an inflation target is readily understood by the public and is
thus highly transparent. Framing the discussion of monetary policy
around an inflation goal makes it easier for the Fed to communicate
with the public and the markets. It can help decrease uncertainty
about future monetary policy moves, thereby decreasing market
volatility. It can help focus the political debate on what a
central bank can do in the long run—that is, control inflation,
rather than on what it cannot do, which is permanently increase
economic growth and the number of jobs through expansionary monetary
policy."
Not everyone is convinced about the usefulness
of inflation targets. In a recent study, Ball and Sheridan (2005)
examine a sample of developed countries (members of the OECD)
and compare the performance of those that have adopted inflation
targets with those that have not. They find that while countries
that adopted inflation targets did succeed in reducing inflation,
their macroeconomic performance was no better than countries
that did not adopt inflation targets. They conclude that while
they find no evidence against inflation targeting, "[n]othing
in the data suggests that covert targeters would benefit from
adopting explicit targets" (p. 273).
Other empirical studies have reached different
conclusions. For instance, Swanson (2006) argues that inflation
expectations in the U.S. are not as well anchored as in some
inflation targeting countries. He bases this conclusion on the
finding that measures of long term inflation expectations tend
to go up in response to economic news, such as a higher-than-expected
CPI inflation number. A similar response is not observed in three
countries with explicit inflation targets (the U.K., Canada,
and Sweden).
 In this Economic Letter we examine how
inflation expectations have been affected by the jump in the
price of oil in recent years. The oil shock seems to provide
a natural experiment to study this issue, since the oil shocks
of the 1970s led to sharp increases in inflation in many countries.
Figure 1 plots inflation rates—as measured by the CPI—in the
three countries we examine: Canada, the U.K., and the U.S. The
figure shows that positive oil price shocks were associated with
large increases in inflation during the 1970s, with inflation
rising above 10% in both the U.S. and Canada and above 20% in
the U.K.
Given this history, it would not be surprising
to see financial markets (as well as other agents in the economy)
raise their expectations of inflation following the recent increases
in oil prices. And to the extent that explicit inflation targets
help to stabilize inflation expectations, expected inflation
in countries that do not target inflation should rise by more
than expected inflation in countries that do.
Comparing inflation expectations across countries
The measures of expected inflation we employ
here come from financial markets. To construct a measure of expected
inflation for the U.S. market, we subtract the yield on the 10-year
TIPS (Treasury Inflation-Protected Securities) from the yield
on 10-year Treasury Securities. Thus, we use the difference between
a market-determined nominal yield and a market-determined real
yield as a measure of expected inflation. We repeat this procedure
for the U.K., using comparable securities. However, for Canada
we only have real yields at a 30-year horizon, and so we plot
a measure of inflation expectations at a 30-year horizon.
 Figure 2 plots our measures of inflation expectations
for these three countries together with the price of a barrel
of (West Texas Intermediate crude) oil in dollars since 2000.
The (monthly average) U.S. dollar price of oil has gone from
roughly $27 a barrel in January 2000 to more than $74 in July
2006. Importantly, though, the dollar has depreciated against
both the Canadian dollar and the pound. So while the U.S. dollar
price of oil is up by nearly 173% over this period, the Canadian
dollar price is up about 113% while the price in British pounds
is up about 143%. The point is that for these two countries the "oil
price shock" has been smaller than it has been for the U.S.;
if everything else were the same across countries, the experience
of the 1970s would lead one to expect U.S. inflation expectations
to rise by more than inflation expectations in Canada or the
U.K.
Turning to the figure, the first thing one notices
is that inflation expectations in all three countries have been
relatively stable—even though oil is now more than two-and-a-half
times as expensive as it was at the beginning of 2000. Further,
the net increase in inflation expectations over this period has
not been very large. In the U.S., expected inflation rose from
2.3% in January 2000 to 2.6% in July 2006, in Canada it rose
from 2.3% to 2.7%, while in Britain it actually fell from 3.5%
to 2.9%. The stability of inflation expectations since early
2004 is particularly striking, especially since this is the period
over which oil prices began to rise at a faster pace. Specifically,
the price of oil averaged close to $34 per barrel in January
2004 and was about $40 per barrel higher in July 2006. (By contrast,
it rose just about $7 per barrel over the previous four years.)
Remarkably, Figure 2 indicates that there has been almost no
increase in inflation expectations over this period.
It is worth noting that for the U.S., these results
are similar to those obtained from the survey of professional
forecasters. The forecasts for inflation over the next ten years
averaged 2.5% in the survey conducted in the first quarter of
2000, as well as in surveys conducted in the first quarter of
2004 and the third quarter of 2006.
Now, it is possible to argue that inflation expectations
have not changed much over this period because markets were expecting
a substantial increase in the price of oil and had factored this
into their inflation forecasts at that time. But this argument
is easily refuted with the help of data from futures markets.
As of January 2004, oil futures data indicated that markets expected
oil to average $29.5 per barrel one year ahead and $27.6 two
years ahead. Thus, the recent price of oil is about $50 per barrel
higher than what markets were expecting at the beginning of 2004.
So—contrary to the experience of the 1970s—markets
do not appear to expect that the recent jump in oil prices will
translate into permanently higher inflation in any of the three
countries that we are examining. Not only that, there is no obvious
difference in how inflation expectations across the three countries
have responded to the oil shock—and this despite the fact that
U.S. inflation has been rising recently and is now above that
prevailing in the other two countries, as shown in Figure 1.
This suggests that inflation expectations in the U.S. are about
as well anchored as they are in the U.K. and Canada, both of
which have explicit inflation targets.
A caveat and some possible explanations
It is possible that there have been some other
changes in the economy or the economic outlook over this period
which could have the effect of offsetting the impact that oil
price shocks might have on expected inflation. However, it is
not obvious what these might be. And as for the behavior of U.S.
inflation expectations relative to those in Canada and the U.K.,
it is worth recalling that the U.S. dollar has fallen relative
to both the British pound and the Canadian dollar over this period.
If anything, the falling dollar would be expected to push both
actual and expected inflation in the U.S. above that in the U.K.
and Canada (even apart from what these currency movements imply
for the size of the oil price shock in the three countries).
It is then natural to wonder about why U.S. inflation
expectations appear well anchored. One thing that the U.S. has
in common with the other two countries is that it has brought
inflation down from the high levels observed in the 1970s and
kept it low for a while now. This achievement (which is not limited
to the three countries under discussion) is likely to have strengthened
the public's belief that the central bank authorities are committed
to keeping inflation low. Indeed, in the U.S., Fed officials
have repeatedly emphasized the need to keep inflation low in
order to achieve maximum sustainable growth.
More recently, several Fed officials have talked
about a "comfort zone" for inflation, a term that both
financial markets and the press refer to fairly frequently. It
is possible that the markets think of this zone as a de facto
target range, even though neither the Fed nor Congress have announced
any formal inflation targets. Indeed, in a recent paper, Goodfriend
(2005) argues that the recent successes of monetary policy "…can
be attributed in large part to inflation-targeting policy procedures
that the Fed has adopted gradually and implicitly over the last
two decades" and that "…some form of inflation targeting
is likely to remain at the core of Fed monetary policy indefinitely" (p.
311).
Again, not everyone agrees. Commenting on the
paper by Goodfriend, then-Governor Donald Kohn (2005) argued
that the Fed has not pursued an inflation target but, instead,
has implemented policy in a flexible manner, often behaving in
ways that would be inconsistent with inflation targeting; the
Fed has achieved greater credibility over time, and expectations
have become well anchored, because monetary policy has kept inflation
low for a sustained period.
Conclusions
Contrary to what the experience from the 1970s
might suggest, the recent substantial increase in the price of
oil does not appear to have led to a noticeable jump in inflation
expectations in the U.S. In this respect, the U.S. experience
seems similar to the experiences of Canada and the U.K. This
suggests that inflation expectations in the U.S. are reasonably
well anchored and that they may be about as well anchored as
they are in countries that have announced inflation targets.
The debate about the reasons for this is not settled yet: The
Fed may have acquired greater credibility because it has kept
inflation low for a sustained period of time now or because the
public believes that the way the Fed is currently practicing
monetary policy is not very different from inflation targeting
as practiced by some other countries.
Bharat Trehan
Research Advisor
with Jason Tjosvold
Research Associate
References
Ball, Laurence, and Niamh Sheridan. 2005. "Does
Inflation Targeting Matter?" In The Inflation-Targeting
Debate, eds. Ben Bernanke and Michael Woodford. Chicago:University
of Chicago Press, pp. 249-276.
Goodfriend, Marvin. 2005. "Inflation Targeting
in the United States?" In The Inflation-Targeting Debate,
eds. Ben Bernanke and Michael Woodford. Chicago:University of
Chicago Press, pp. 311-337.
Hoover, Kevin, and Stephen Perez. 1994. "Post
Hoc Ergo Propter Hoc Once More. An Evaluation of 'Does Monetary
Policy Matter?' in the Spirit of James Tobin." Journal
of Monetary Economics 34, pp. 47-73.
Kohn, Donald. 2005. "Comment on 'Inflation
Targeting in the United States.'" In The Inflation-Targeting
Debate, eds. Ben Bernanke and Michael Woodford. Chicago:University
of Chicago Press, pp. 337-350.
Mishkin, Frederic S. 2004. "Why the Fed
Should Adopt Inflation Targeting." International Finance 7(1),
pp. 117-127.
Swanson, Eric. 2006. "Would
an Inflation Target Help Anchor U.S. Inflation Expectations?" FRBSF
Economic Letter 2006-20 (August 11).
Opinions expressed in this newsletter
do not necessarily reflect the views of the management
of the Federal Reserve Bank of San Francisco or of the
Board of Governors of the Federal Reserve System. Comments?
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