Inflation Targeting and Predictive Power of Term Spreads

Abstract

Many studies have investigated the predictive contents of the term spreads for future inflation and real activity since the 1990s, which was the time when some countries adopted inflation targeting (IT). As notable as the number of studies are the diversity and heterogeneity of the empirical findings on this issue across countries and over time. In this paper, we attempt to assess whether IT is responsible for the changes in the forecasting power of the term spreads for inflation. If future inflation is anchored to the target rate under an IT regime, then changes in the spread would contain information other than the future inflation, thereby reducing the predictive contents for future inflation. We test this hypothesis by (1) comparing the forecasting power of the term spread for inflation in a group of inflation-targeting countries before and after adopting IT and (2) comparing this power with the forecasting power in a group of countries that have not adopted IT. Findings support the hypothesis overall, but results are weakened when the interest rate is included in the forecasting equation.