Working Paper: NBER ID: w4604
Authors: Lars E. O. Svensson
Abstract: A simple test of inflation target credibility is constructed by subtracting the maximum and minimum inflation rates consistent with the inflation targets from the yields to maturity on nominal bonds. This results in a target-consistent range of real yields on nominal bonds. If expected real yields, or market real interest rates on real bonds if such are available, fall outside the range of target- consistent real yields, credibility is rejected. Two concepts of credibility, called absolute credibility and credibility in expectation, are distinguished. The inflation targets of Canada, New Zealand and Sweden are examined with convenient diagrams over yields to maturity and forward interest rates.
Keywords: inflation targeting; credibility; interest rates
JEL Codes: E31; E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Credibility of inflation targets (E52) | Market real interest rates (E43) |
| Market real interest rate falls outside target-consistent range (E43) | Rejection of absolute credibility (D81) |
| Market real interest rate falls outside target-consistent range (E43) | Rejection of credibility in expectation (D84) |
| Small inflation risk premium (E31) | Market real interest rates close to expected real yields on nominal bonds (E43) |
| Market agents expect future real yields to fall outside target-consistent range (E43) | Rejection of both types of credibility (D81) |
| Absence of a well-functioning market for real bonds (G19) | Reliance on other indicators for credibility assessments (D79) |