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FRBSF

WEEKLY LETTER

Number 95-01, January 6, 1995

The Credibility of Inflation Targets
In the last few years a number of countriesincluding Canada, New Zealand, Sweden, and
the United Kingdom-have sought to increase
their credibility as inflation-fighters byannouncing inflation targets. But does announcing targets
make people believe that the central bank really
will do what is necessary to hit those announced.
targets?
In this Weekly Letter I discuss a simple test for
credibility as well as the results from applying
this test to three of these four countries. I then
apply the same test to the U.S., where-even
though no formal targets have been set-Chairman Greenspan as we!! as other members of the
FOMC repeatedly have said that they would like
to reduce inflation further.

A test for credibility
Svensson (1993) presents a relatively straightforward measure of the credibility of announced
inflation targets. The key to this test is what he
calls the "target-consistent real rate:' This is simply the difference between the nominal interest
rate and the targeted inflation rate. For example,
if the targeted inflation rate for the next three
years is 2 percent and the nominal interest rate
on a three-year, risk-free bond is 7 percent, then
the target-consistent real rate is 5 percent.
The "target-consistent" real rate is similar to
the more common concept of the expected real
rate of interest, which is simply the difference
between the nominal rate and the expected
inflation rate. Indeed, Svensson's test can be understood as a comparison between the targetconsistent rate and the expected real rate. A
target-consistent rate noticeably higher than the
expected real rate suggests that the public is expecting an inflation rate above the central bank's
target range. In other words, it suggests that the
inflation target is not credible.
A target-consistent rate that is close to the expected real rate generally suggests that the
inflation target is credible. However, an unu-

sually high target-consistent rate by itself may
suggest that the target is not credible, even if it is
close to the expected real rate. For instance, the
public might think that while the central bank
would like lower inflation, there could be some
circumstances under which it would be unwilling to take the necessary action. Thus, the public
could be uncertain about what the central bank
would do in the future. The existence of uncertainty about future inflation would mean that
lenders would demand a premium for inflation
risk. An unusual amount of uncertainty would
lead to an unusually high inflation risk premium,
leading in turn to a high target-consistent rateeven if the public did not think it likely that inflation would exceed the central bank's target.
Thus, an unusually high target-consistent rate
suggests that we should reject credibility, even if
this rate is the same as the expected real rate.
Some judgment is involved inthis decision,
since the expected real rate can move around;
for instance, rising credit demands over the
course of an expansion are likely to push up this
rate. The need for judgment is compounded by
the fact that we cannot observe the expected real
rate. Consequently, we must use some kind of
proxy for it. The proxy used most often is the
realized real rate. This rate is constructed by subtracting actual inflation over a given period from
the nominal interest rate that prevailed at the beginning of the period.

Some examples
Svensson. applies this test to three countries that
have recently announced inflation targets: Canada, New Zealand, and Sweden. To illustrate his
method, I will focus on his results for Canada,
and then briefly discuss the others. In February
1991, the Bank of Canada announced an inflation
target of 3 percent per year by the end of 1992,
2112 percent by mid-1994 and 2 percent by the
end of 1995. Inflation was allowed to vary within
1 percentage point of these values. Inflation fell
sharply in 1992; however, nominal rates were
slower to decline. The minimum target-consistent

FABSF
rate on 5-year Canadian government bonds was
around 5Yz percent in early 1992 and the maximum was around 7V2 percent. The minimum
rate fell to around 5 percent after mid-1992 and
fell below 4 percent after mid-1993.
Testing for credibility involves making a judgment about whether expected real rates on
5-year Canadian bonds can go as high as 5
to 6 percent per year. To answer this question
Svensson looks at the realized real rate on these
bonds since 1982. He finds that the rpte has fluctuated between 4 and 9 percent per year, with a
mean that exceeds 6 percent. Thus, the expected
real return on 5-year Canadian bonds appears to
be of the same magnitude as the target-consistent
real rate, and we cannot reject inflation target
credibility for Canada.

To answer this question I use 1-year rates expected to prevail at various points in the future,
specificall~ the 1-year rate expected to prevail
next year, 3 years ahead, 10 years ahead and
30 years ahead. For each of these horizons I
calculate the minimum and maximum targetconsistent real rates. Looking at rates at specific
points in the future allows Us to be more explicit
about when (if ever) markets expect the Fed to
bring the inflation rate down to between 0 and 2
percent. The market's expectations as of November are plotted in Figure 1, which shows that the
minimum target-consistent rate is around 6 percent once we move beyond the 1-year horizon
while the maximum is around 8 percent. These
are unusually high levels; expected real rates
around 2 to 3 percent seem closer to conventional wisdom.

In the case of New Zealand, the target-consistent
minimum real rate was as high as 9 percent when
inflation targets were first announced in 1991.
Svensson concludes that this level of rates is too
high to be consistent with credible targets. However, the target-consistent real rate has fallen
below 5 percent since then, suggesting that the
inflation targets have become more credible over
time. Finall~ Sweden announced inflation targets
in early 1993. While credibility can be rejected
at a 5-year horizon for Sweden, the experience
of Canada and New Zealand suggests that this
is not unusual in the early stages after a target is
announced.

4

The U.S. experience

3

As mentioned earlier, the Federal Reserve does
not have explicit target ranges for inflation. Yet
Federal Reserve officials often have stated their
desire for an inflation rate below the current 3
percent rate. For instance, in recent testimony
before the Senate, Chairman Greenspan stated
that most members of the FOMC would like to
see further progress towards price stability over
the medium term (Greenspan 1994). The Chairman has spoken of attaining price stability on
other occasions as well, defining it as a situation
where the inflation rate does not enter into the calculations made by economic agents. For the purposes of this Letter, I interpret the desire to reduce
inflation below the prevailing rate, as well as these
statements in favor of price stability, as implying
an inflation target of between 0 and 2 percent.
I then ask whether markets believe the Fed will
take the actions required to achieve this inflation
rate.

2

Figure 1
U.S.: Target-Consistent l-Year Real Rates
Percent

9

8
7
6

Minimum

\

Maximum

Â¥

5

1

o
3

10

30

Years Ahead

To provide some perspective on this, Figure 2
plots the real ized real rate on the 1-year Treasury
bill since the early 1950s. It turns out that the realized real rate has averaged roughly 1.8 percent
over this period. However, it has been noticeably
higher since the 1980s, averaging 4.2 percent.
The only time the real rate rose above 6 percent
was in the early 1980s. However, as also shown
in Figure 2, inflation declined extremely rapidly
over this period. Since it is likely that such a

A~re2

u.s.:

.

Realized l-Year Real Rate and Inflation

Percent
15

10

5

Conclusions .
In this Letter we have discussed a simple test of
inflation target credibility. The experience of several countries that have explicit inflation targets

-5
Real Rate
-1 0

+H-t+t-t+t-H-t+H+++t+H-t+H+t-t+t-H-t+H+t++

59

65

71

77

83

the expected real rate above the average real ized
real rate of 1.8 percent over the posFwar period,
it is unlikely that they have pushed it above the
4.2 percent realized return of the 1980s. Thus,
the minimum target-consistent rate shown in
Figure 1 seems too high, which suggests that
markets do not think it likely that the Fed will
push inflation below 2 percent in the foreseeable
future. And even if markets were predicting a 2
percent inflation rate, the inflation risk premium
implied by the prevailing target-consistent rate
suggests that markets are extremely uncertain
about this forecast.

89

rapid decline was unexpected, it also is likely
that the realized real rate is too high an estimate
of the expected real rate over this period.
Figure 2 suggests that an expected real rate
above 6 percent was extremely unlikely in the
past. Could the expected real rate have moved
up recently? Some commentators have suggested
that unusually high credit demands resulting
from unusually rapid growth in East Asia as well
as the restructuring in Eastern Europe are likely to
have pushed up real interest rates. While this is a
plausible hypothesis, it is hard to make a judgment on it without supporting evidence. In any
event, even if these developments have pushed

suggests that it takes a while for these targets to
become credible. In the case of the U.S., while
Fed officials often have expressed a desire for
price stability, at this point markets do not appear
convinced that this desire will translate into inflation rates between 0 and 2 percent.

Oharat Trehan
Research Officer
References
Greenspan, Alan. 1994. "Statement" to the Senate
Committee on Banking, Housing and Urban Affairs, July 20, 1994. Reprinted in the Federal
Reserve Bulletin (September) pp. 793-799.
Svensson, Lars ED. 1993. "The Simplest Test of Inflation Target Credibility!' NBER Working Paper
No. 4604 (December).

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor or to the author•... Free copies of Federal Reserve publications can be
obtained f.rom the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120.
Phone (415) 974-2246, Fax (415) 974-3341.

Research Department

Federal Reserve
Bank of
San Francisco
P.O. Box 7702
San Francisco, CA 94120

Printed on recycled paper Q ....t.
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~ ~

Index to Recent Issues of FRBSF Weekly Letter

DATE NUMBER TITLE

AUTHOR

6/10
6/24
7/1
7/15
7/22
8/5
8/19
9/2
9/9
9/16
9/23

Schmidt
Sherwood-Call/Schmidt
Trehan
Cogley/Schaan
Levonian
Walsh
Walsh
Throop
Sherwood-Call
Glick
Huh/Kim
Huh/Kim
Trehan
Laderman
Kasa
Zimmerman
Moreno
Gabriel
Kasa
Zimmerman
Booth/Chua
Mattey
Spiegel

9130

10/7
10/14
10/21
10/28
11/4
11/11
11/18
11/25
12/9
12/23
12/30

94-22
94-23
94-24
94-25
94-26
94-27
94-28
94-29
94-30
94-31
94-32
94-33
94-34
94-35
94-36
94-37
94-38
94-39
94-40
94-41
94-42
94-43
94-44

Manufacturing Bias in Regional Policy
An "Intermountain Miracle"?
Trade and Growth: Some Recent Evidence
Should the Central Bank Be Responsible for Regional Stabilization?
Interstate Banking and Risk
A Primer on Monetary Policy Part I: Goals and Instruments
A Primer on Monetary Policy Part II: Targets and Indicators
Linkages of National Interest Rates
Regional Income Divergence in the 1980s
Exchange Rate Arrangements in the Pacific Basin
How Bad is the "Bad Loan Problem" in japan?
Measuring the Cost of "Financial Repression"
The Recent Behavior of Interest Rates
Risk-Based Capital Requirements and Loan Growth
Growth and Government Policy: Lessons from Hong Kong and Singapore
Bank Business Lending Bounces Back
Explaining Asia's Low Inflation
Crises in the Thrift Industry and the Cost of Mortgage Credit
International Trade and U.S. Labor Market Trends
EU + Austria + Finland + Sweden + ?
The Development of Stock Markets in China
Effects of California Migration
Gradualism and Chinese Financial Reforms

The FRBSF Weekly Letter appears on an abbreviated schedule in june, july, August, and December.