Academic journal article Seoul Journal of Economics

Inflation Targeting and Predictive Power of Term Spreads

Academic journal article Seoul Journal of Economics

Inflation Targeting and Predictive Power of Term Spreads

Article excerpt

(ProQuest: ... denotes formulae omitted.)

I. Introduction Over the past two decades, many studies have analyzed whether the yield spread contains predictive contents for future real activity and inflation in many industrialized countries. The empirical evidence for the predictive power of the yield spread for real activity is relatively strong, but the predictive power for future inflation appears to have decreased significantly or disappeared over time in most countries. In this paper, we show that the adoption of inflation targeting (IT) is responsible for the time variation in the predictability of inflation using the term spread in relation to that of output growth across countries and over time.

Around the 1980s, the term structure of interest rates emerged as an active major research topic in several academic fields. The modern asset pricing literature pertaining to the factors underlying the term structure was initiated by the work of Vasicek (1977) and Cox, Ingersoll, and Ross (1985). From a theoretical point of view, the forward-looking nature is inherently an essential characteristic of the bond yields, and many empirical studies have investigated the predictive power of the term structure for the future output growth and inflation since the 1990s. Another recent body of research, the macro-finance literature that started in the 2000s, primarily focuses on the relationship among the level, slope, and curvature factors in the term structure and the macro-variables, such as inflation target of the central bank, actual inflation, and real activity. Rudebusch and Wu (2008), Ho?rdahl, Tristani and Vestin (2006), and Bekaert, Cho, and Moreno (2010) found that the level factor, which is primarily driven by the short-term interest rates, accounts for much of the inflation target or the long-run inflation rate, whereas the slope, which is often proxied by the term spread, has a marginal relationship with inflation or real activity.

The keys to understanding the term structure are the dynamics of the short-term nominal interest rates and the expectation formation of the market participants on future short-term interest rates, both of which are heavily influenced by monetary policy. Most industrialized countries replaced their primary monetary policy instrument, monetary aggregates, with the short-term interest rate in the 1980s. This policy change implies that the equilibrium of short-term interest rates is directly controlled by the central bank. Accordingly, the long-term bond market participants have changed the way they form expectations of future short-term interest rates. This explains that the objective, instrument, and conduct of monetary policy have been taken into account in a vast majority of research papers in the aforementioned literature.

Another important change in the history of monetary policy is that several developed countries adopted IT in the early 1990s, shifting the preference of the central bank toward stabilizing future inflation variations. Various aspects of IT framework exist, as discussed by Bernanke and Mishkin (1997), but a central implication is that a successful implementation of IT would be able to anchor the expectations of the future inflation rates of private agents to the target inflation rate. This in turn leads to changes in the information composition embedded in the longterm bond yields. However, few studies systematically investigated the effects of IT on long-term bond yields and the changes in the information structure underlying the predictable contents of the term structure for output growth and inflation.

This issue is the main topic that we want to address in this paper. Specifically, we want to identify the relative information on future inflation and output growth contained in the term spread. Our main hypothesis is that under IT, the term spread contains little information on the changes in inflation because IT anchors the future inflation to the target rate, canceling out the target rate component embedded in the long-term bond yield and the short-term interest rate. …

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