Has inflation targeting become less credible?

Summary

Focus

Since the 2008 financial crisis, oil prices have become highly correlated with inflation expectations for the medium term. This occurred in several countries, implying a global phenomenon. To trace its origins, we decompose oil prices into two factors: one capturing global aggregate demand and the second capturing oil-specific elements. Our measure of global demand is based on the strong co-movement of commodity prices. The oil-specific elements include OPEC's strategic behavior and shocks to oil demand caused by the weather. We use this decomposition to explain changes in global inflation expectations.

Contribution

Central bankers were concerned that the increased correlation between inflation expectations and oil prices might indicate an un-anchoring of expectations. If this were the case, the credibility of inflation targeting might be declining. We test for un-anchoring using a framework based on a global Phillips curve. This framework allows us to trace the origins of the change that occurred after the global crisis.

Findings

We find that global aggregate demand has affected inflation expectations more since the crisis than it did in the past. Meanwhile, the effect of oil-specific factors remained low and stable. Since oil prices convey information about aggregate demand, their correlation with expectations has increased. Does this change indicate that expectations became un-anchored? Our model for global expectations suggests otherwise. We find that, after the crisis, inflation itself was perceived to react more strongly to aggregate demand. Rational agents thus adjusted their expectations more strongly when aggregate conditions changed. It appears that inflation targeting has remained credible.

Abstract

Beginning with the global financial crisis (2008) the correlation between crude oil prices and medium-term and forward inflation expectations increased leading to fears of their un-anchoring. Using the first principal component of commodity prices as a measure for global aggregate demand, we decompose nominal oil prices to a global demand factor and remaining factors. Using a Phillips Curve framework we find a structural change after the collapse of Lehman Brothers when inflation expectations reacted more strongly to global aggregate demand conditions embedded in oil prices. Within this framework we cannot reject the hypothesis that expectations remained anchored.

JEL classification: E52, E58, E31, E32

Keywords: Inflation targeting, inflation expectations, monetary policy, oil prices, anchoring, credibility