Does Inflation Targeting Affect the Dispersion of Inflation Expectations?
Capistran, Carlos, Ramos-Francia, Manuel, Journal of Money, Credit & Banking
INFLATION TARGETING (IT) is a monetary policy strategy that has been gaining popularity around the world. Three main benefits, all interrelated, have been associated with IT. First, it successfully lowers inflation and makes it less volatile (Bemanke et al. 1999, Johnson 2002, Levin, Natalucci, and Piger 2004, Vega and Winkelried 2005, Mishkin and Schmidt-Hebbel 2007, Goncalves and Salles 2008). Second, it reduces the real costs of disinflations (Mishkin and Schmidt-Hebbel 2007, Goncalves and Salles 2008). Finally, it anchors long-run inflation expectations at or very close to the inflation target (Bernanke et al. 1999, Johnson 2002, Levin, Natalucci, and Piger 2004, Vega and Winkelried 2005, Gurkaynak, Levin, and Swanson 2006, Mishkin and Schmidt-Hebbel 2007, Goncalves and Salles 2008). Of these, the effect on inflation expectations is, in principle, straightforward, since a key aspect that separates IT from other sensible monetary policies is the public announcement of a numerical target, and the subsequent referral to it in central bank communications. In fact, it is possible that the impact of IT on inflation and on other macroeconomic variables may come through its effect on inflation expectations and on the expectations formation process: e.g., IT could coordinate expectations and, in this way, become the nominal anchor of the economy, or it could be thought of as a commitment mechanism that increases the signal-to-noise ratio in the economy, helping people to make a better informed allocation of resources. For this reason, and in contrast to other investigations that concentrate on the effects of IT on inflation or on macroeconomic variables, we concentrate on the effect of IT on inflation expectations.
By making the inflation target explicit, IT provides a focal point that may anchor inflation expectations. If the central bank does not announce a target and if the performance of the central bank is not evaluated based on a number or a range, then people in the economy need not have the same expectation about the future stance of monetary policy and, therefore, inflation expectations need not be anchored. Indeed, Gurkaynak, Levin, and Swanson (2006), using inflation expectations extracted from market instruments, provide evidence that expectations in Canada, the United Kingdom, and Sweden, all IT countries, seem to be less sensitive to macroeconomic news than inflation expectations in the United States, a non-IT country.
IT may not only affect the level of inflation expectations but also the dispersion of these expectations across economic agents. As an example, take two otherwise identical countries with monetary policies conducive to low and stable inflation, but one with an explicit inflation target (the IT country) and the other with an implicit one. The potential benefit for the IT country is that the target becomes a focal point for the coordination of expectations among agents. In contrast, in the country with an implicit target, economic agents have to estimate the target in order to form their inflation expectations and, therefore, need not have the same inflation expectation. As a result, the dispersion of inflation expectations would be larger in the non-IT country.
In this paper we study how the choice of a particular monetary policy scheme, IT, affects the heterogeneity in inflation expectations. The importance of this heterogeneity for macroeconomic analysis has been emphasized by several authors. Lucas (1973), Phelps (1970), Sims (2003), and Woodford (2002) show, using models of imperfect information, that the real costs of nominal movements in the economy may be related to the dispersion of inflation expectations. Mankiw and Reis (2002) use a model with sticky information and, hence, with dispersion in inflation expectations, to obtain the observed delayed response of inflation to monetary policy shocks. More recently, Mankiw, Reis, and Wolfers (2004, p. 2) go as far as suggesting that "disagreement [about inflation expectations] may be a key to macroeconomic dynamics. …