Abstract
This paper examines the implications of the expectations theory of the term structure of interest rates for the implementation of inflation targeting. We show that the responsiveness of the central bank’s instrument to the underlying state of the economy is increasing in the duration of the long-term bond. On the other hand, an increase in duration will make long-term inflationary expectations - and therefore also the long-term nominal interest rate - less responsive to the state of the economy. The extent to which the central bank is concerned with output stabilisation will exert a moderating influence on the central bank’s response to leading indicators of future inflation. However, the effect of an increase in this parameter on the long-term nominal interest rate turns out to be ambiguous. Next, we show that both the sensitivity of the nominal term spread to economic fundamentals and the extent to which the spread predicts future output, are increasing in the duration of the long bond and the degree of structural output persistence. However, if the central bank becomes relatively less concerned about inflation stabilisation the term spread will be less successful in predicting real economic activity.
Highlights
Since the early 1990s the conduct of monetary policy in many countries has switched to a regime of direct inflation targeting
We show that the optimal short-term interest rate will be more responsive to the underlying state of the economy as the maturity of the long-term bond – measured by its duration – increases
We show that the long-term nominal interest rate will be less responsive to the current state of the economy as a result of an increase in duration
Summary
Since the early 1990s the conduct of monetary policy in many countries has switched to a regime of direct inflation targeting. This change was triggered either as a result of the breakdown of the relationship between money growth rates and inflation (New Zealand and Canada) or because of the disappointment following the use of exchange rates as an intermediate target (United Kingdom, Sweden and Finland).. All central banks implement monetary policy by setting the price at which the banking system’s systematic shortage of central bank balances on the interbank money market will be relieved.. For an analysis in the context of a New Keynesian DSGE model see Woodford (2003)
Talk to us
Join us for a 30 min session where you can share your feedback and ask us any queries you have