A Credibility Proxy: Tracking US Monetary Developments

Abstract

The purpose of this paper is two-fold: first, we propose a method for checking empirically whether inflation expectations are anchored in the long run, and at what level. The extent of anchoring then serves as a proxy for the credibility of the monetary authority. Second, to assess how well this measure proxies credibility, we cross-check it against periods for which the level of credibility is known and generally agreed upon. To this end, we apply our measure to the US inflation history since 1963, which includes both the period of the Great Inflation, in which credibility was poor and deteriorating, as well as the period of the Great Moderation during which credibility in the monetary authority was gradually re-established. Finally we check what our measure of credibility tells us about the crisis period.

The Time-Varying Degree of Inflation Expectations Anchoring

“…In contrast to constant parameter models with regime-shifts, the more flexible time-varying parameter approach is able to detect that monetary policy re-anchored inflation expectations rather quickly. On the other hand, even if a time-varying model is applied, the danger of de-anchored inflation expectations can be underestimated if one of the two sources of deanchoring is neglected, see Demertzis et al (2012). …”

The time-varying degree of inflation expectations anchoring

“…Therefore, in line with Demertzis et al (2012), our empirical analysis is based where the anchoring-parameter drops substantially below the value implied by perfect anchoring. This explains why constant parameter models with endogenous breaks tend to produce evidence in favor of an extended deanchoring period.…”

“…According to Bomfim and Rudebusch (2000), a significant impact of inflation on long-term inflation expectations would indicate a lack of credibility and a de-anchoring of expectations. Demertzis et al (2012) conclude that U.S. long-term inflation expectations have been well-anchored in recent years, including the financial crisis, because they find that inflation expectations were not significantly affected by lagged rates of inflation.…”

“…Accordingly, the anchoring parameter, 1 − θ t1 − θ t2 , is also time-varying and, multiplied by 100, may be interpreted as the percentage at which expectations are anchored in period t. Since we additionally account for de-anchoring due to short-term expectations, our measure of the degree of inflation expectations anchoring generalizes the credibility proxy introduced by Demertzis et al (2012).…”

“…In contrast to constant parameter models with regime-shifts, the more flexible time-varying parameter approach is able to detect that monetary policy re-anchored inflation expectations rather quickly. On the other hand, even if a time-varying model is applied, the danger of de-anchored inflation expectations can be underestimated if one of the two sources of deanchoring is neglected, see Demertzis et al (2012). For estimation purposes, we cast the time-varying parameter model for inflation expectations…”