Flexible inflation targeting and stock market volatility: Evidence from emerging market economies

Abstract

Since the recent financial crisis, inflation targeting has been considered as one of the causes of the authorities’ unresponsiveness to the buildup of financial instability. Related research has either emphasized the effects of the central bank instrument and/or outcome or exclusively the impact of a unique central bank institutional characteristic, but never all of them as a core part of a unified framework. We fulfill this gap by providing evidence on whether the stock market volatility from Flexible Inflation Targeting (FIT) countries is less than volatility from non-FIT countries. Using data on a large set of emerging and employing causal inference methods, we examine the impact of FIT on stock market volatility. The results demonstrate that FIT is effective in containing volatility. By anchoring market operators’ expectations, FIT shapes the risk premium, which compensates for inflation uncertainty by lowering its main component, i.e. uncertainty, hence eventually bringing down the stock market volatility.