The paper investigates the presence of monetary policy credibility in eight countries by filtering the residuals from an “augmented” Phillips curve. Two of the eight countries (US and New Zealand) exhibit robust credibility effects across samples. Two countries (South Africa and the UK) exhibit credibility effects in the sample involving the 1990s, but these effects disappear in the sample beginning in 2000. The rest of the countries do not exhibit monetary policy credibility. Given that seven of the eight countries have adopted an explicit inflation-targeting framework, we conclude that there is very weak evidence that this framework enhances monetary policy credibility. These results are however sensitive to how inflation and the output gap are measured.
This paper uses a Phillips-curve based method to investigate the extent of central bank credibility in eight countries. Since Kydland and Prescott (1977), credibility has been viewed as an important ingredient in the conduct of monetary policy. According to Blinder, Ehrmann, Fratzscher, De Haan, and Jansen (2008) credibility helps with making disinflation less costly. Credibility also helps the central bank gain public support for its actions. This view is shared by, for example, Bertola and Caballero (1992), Bertola and Svensson (1993) and Demertzis, Marcellino, and Viegi (2008). However, empirical analyses suggest that central banks are not perfectly credible. This may be due to the fact that, as Lohman (1992) argues, in order to optimize monetary policy commitment and retain credibility, central banks must be allowed to exercise flexible policy responses to unforeseen contingencies.
The most relevant place where the theory of credibility is applied is the Phillips curve. Blinder (2000) notes that the so-called credibility hypothesis says that perfectly credible pre-announcements of disinflation will reduce inflation expectations abruptly. Therefore if the central bank is credible relatively low unemployment is required to bring about a drastic fall in the inflation rate. By implication, slight increases in the interest rate must deliver drastic declines in inflation through a downward revision of inflation expectations, thereby shifting the Phillips curve downwards. Ultimately therefore, the test for credibility must involve a test of the extent to which inflation expectations are negatively related to changes in the short-term interest rate.
There are at least two ways in which inflation expectations are extracted. One way relies on surveys as in Berk (1999), Aron and Muellbauer (2007), Ang, Bekaert, and Wei (2007), Arnold and Lemmen (2008) and Henzel (2008), and the other extracts inflation expectations from the bond rate. In the latter case, by combining the Fisher relation and the expectations theory of the term structure, it can be shown that the bond rate contains information about future inflation. Goodfriend (1993) and Mehra (1996) for example, argue that the term structure is useful in predicting movements of future inflation rates for some periods for the US.
In this paper, we investigate the extent to which monetary policy is credible in eight countries: South Korea, South Africa, Mexico, New Zealand, Australia, Canada, the United States and the United Kingdom. The contribution of this paper is that it uses the Phillips curve to extract inflation expectations. The hypothesis that this paper seeks to prove is that, if monetary policy is credible, there will be a negative relationship between inflation expectations and the nominal interest rate, as pointed out by Blinder (2000).
The paper is structured as follows: Section 2 derives the model that extracts inflation expectations from the Phillips curve, and uses the nominal interest rate to test for the presence or absence of monetary policy credibility. Section 3 provides empirical results of the tests and Section 4 concludes.
This paper extracts inflation expectations from the Phillips curve in order to test for the credibility of monetary policy in eight countries. We argue that the presence of credibility should translate into a negative relationship between changes in the short-term nominal interest rate and inflation expectations. We do not find significant and robust credibility of monetary policy in the countries in our sample except for the UK, US and New Zealand.
This finding casts serious doubt on the claims that monetary policy, especially with the advent of inflation targeting, has gained in credibility by way of affecting inflation expectations. We propose that future research be undertaken to reconcile the Phillips curve approach that we use in this paper and the one that is based on surveys. Furthermore, future research may have to explore alternative ways in which credibility effects find expression in the Phillips curve.
