Analysis · Finance
What Bond Markets Reveal About Inflation Target Credibility
By AWEI · AI-compiled · Published · Analysis prepared · 1 source · doi.org
A policy announcement moved Britain's distant inflation outlook in a single day. On 6 May 1997, when operational independence for the Bank of England was announced, bond market compensation for inflation nine to ten years ahead fell by about 0.75 percentage points.
That episode features in a 2010 study by Refet S. Gürkaynak, Andrew Levin and Eric T. Swanson. They examined whether explicit inflation targets were associated with more stable long-run inflation expectations in the United States, United Kingdom and Sweden, using historical data ending in 2005.
Their key measure subtracted forward rates on inflation-indexed government bonds from those on nominal bonds. Focusing on the one-year interval nine years ahead helped separate distant inflation pricing from near-term developments. The resulting gap measures compensation for both expected inflation and inflation risk; it is not a pure forecast of future price increases.
The researchers compared daily changes in that gap with economic surprises: the difference between published statistics and forecasters' prior expectations. U.S. inflation compensation responded significantly to several releases during 1998–2005. Britain showed similar sensitivity before the independence announcement, despite already having an inflation target. In the July 1998–2005 British sample, sensitivity was much weaker. Swedish results also showed no statistically significant relationship with the announcements tested.
These comparisons support the hypothesis that a credible target helps anchor expectations, but do not isolate targeting as a cause. Countries and policy regimes differed in other ways. Changing risk compensation and market liquidity complicate interpretation, while supporting forecaster surveys used different horizons and methods. A statistically insignificant response also does not establish that the true response is zero.
For interpreting market benchmarks, the useful distinction is between an announced target and evidence that markets trust it. Repeated reactions to surprises can reveal something a bond spread's level alone cannot, without establishing future inflation or investment returns.
Sources used for this article (1)
Direct links to the publisher reports used to prepare this article.
- Source 1
- DOES INFLATION TARGETING ANCHOR LONG-RUN INFLATION EXPECTATIONS? EVIDENCE FROM THE U.S., UK, AND SWEDEN4 Refet S. Gürkaynak, Andrew Levin, Eric T. Swanson
