Inflation Targeting and Predictive Power of Term Spreads
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Many studies have investigated the predictive contents of the termspreads for future inflation and real activity since the 1990s, whichwas the time when some countries adopted inflation targeting (IT). Asnotable as the number of studies are the diversity and heterogeneityof the empirical findings on this issue across countries and over time. In this paper, we attempt to assess whether IT is responsible for thechanges in the forecasting power of the term spreads for inflation. Iffuture inflation is anchored to the target rate under an IT regime,then changes in the spread would contain information other thanthe future inflation, thereby reducing the predictive contents for futureinflation. We test this hypothesis by (1) comparing the forecastingpower of the term spread for inflation in a group of inflation-targetingcountries before and after adopting IT and (2) comparing this powerwith the forecasting power in a group of countries that have notadopted IT. Findings support the hypothesis overall, but results areweakened when the interest rate is included in the forecastingequation.
Abstract
Many studies have investigated the predictive contents of the termspreads for future inflation and real activity since the 1990s, whichwas the time when some countries adopted inflation targeting (IT). Asnotable as the number of studies are the diversity and heterogeneityof the empirical findings on this issue across countries and over time. In this paper, we attempt to assess whether IT is responsible for thechanges in the forecasting power of the term spreads for inflation. Iffuture inflation is anchored to the target rate under an IT regime,then changes in the spread would contain information other thanthe future inflation, thereby reducing the predictive contents for futureinflation. We test this hypothesis by (1) comparing the forecastingpower of the term spread for inflation in a group of inflation-targetingcountries before and after adopting IT and (2) comparing this powerwith the forecasting power in a group of countries that have notadopted IT. Findings support the hypothesis overall, but results areweakened when the interest rate is included in the forecastingequation.
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