When a central bank announces an inflation target in the form of a range between the upper and lower bounds on the future inflation rate, the simplest means of testing whether agents find this target credible is to compute the maximum and minimum future inflation rates consistent with it and subtract them from the nominal yields on government bonds of the corresponding maturity. With a well-functioning market for real bonds, this test involves examining whether the real market interest rate falls between the resulting `target-consistent' minimum and maximum real yields. Without such a well-functioning market for real bonds, however, a credibility test also requires a judgement of whether market agents' expected future real yield is likely to fall between the target-consistent minimum and maximum real yields on the basis of other available information including previous ex post real yields.

In Discussion Paper No. 940, Research Fellow Lars Svensson makes examines the credibility of inflation targets for Canada, New Zealand and Sweden for the period up to the late summer of 1993. He finds inconclusive results for Canada, while inflation target credibility is rejected in the earlier period in New Zealand but not after mid-1992. By August 1993, his tests reject credibility for Sweden's recent inflation targets for a five-year but not for a two-year horizon.

In Discussion Paper No. 941, Svensson considers the effects on macroeconomic targeting of the recent switch of many European currencies to floating rates and the widening of bands for those still remaining within the ERM. The difficulties entailed in identifying appropriate intermediate monetary policy targets should enhance the role of indicators. In particular, forward interest rates may be interpreted as market expectations of future short interest rates when forward term premiums are small. If inflation (foreign exchange) risk premiums are also small, these also indicate the expected future rates of inflation (currency depreciation) and the expected future time-path of the interest rate (while standard yield curves indicate only its expected average level). Forward and spot rate curves contain the same information, but the former separate market expectations for the short, medium and long term more clearly and are therefore more suitable for the design of monetary policies involving measures whose effects may entail long and variable lags. Using long spot rates or bond yields instead would be misleading, since these incorporate expectations of short-term interest rate movements, which long forward rates filter out.

Svensson interprets monetary policy in France, Germany, Sweden, the UK and the US with reference to their forward interest rates during September 1992–September 1993. In Sweden and the UK, long forward rates rose substantially after sterling and the krona were floated and fell to pre-September 1992 levels only in autumn 1993. In contrast, monetary expansion and very low short-term interest rates in the US were followed by a fall in long forward rates, while there is some indication of a rise in French long forward rates after August 1993. Assuming that expected future real interest rates have been quite stable and that these developments therefore reflect changes in long-term inflation expectations, low-inflation monetary policy appears to have been markedly more credible in France, Germany and the US than in the UK or Sweden.

Monetary Policy with Flexible Exchange Rates and Forward Interest Rates as Indicators
The Simplest Test of Inflation Target Credibility
Lars E O Svensson

Discussion Papers Nos. 940-1, April 1994 (IM)