Revisiting Svensson’s test of inflation target credibility

Abstract

I revisit Svensson’s (1993) test of inflation target credibility by applying it to the European Central Bank (ECB)’s credibility regarding the maintenance of price stability. By selecting seven European bond pairs, each consisting of an inflation-linked and nominal bond, I show that Svensson’s test is applicable during relatively calm times but does not work properly during the recent financial and sovereign debt crisis. Risk premia and flight-to-liquidity effects bias yields of both bond types and hamper a meaningful analysis during this time. However, in line with existing literature, the ECB’s credibility can be confirmed during calm financial times.

Keywords:

• inflation indexed
• inflation stabilization
• monetary policy
• central banking
• EMU

JEL Classification:

• E52
• E58
• E31
• E63
• F33

Notes

¹ See Bernanke and Mishkin (1997) for an introduction to inflation targeting and Svensson (2010) for an overview of inflation targeting economies.

² The exact formula for the Fisher equation is , where is the nominal interest rate, the real interest rate and the expected inflation. For very low values, however, the last term becomes extremely small and can be ignored. The Fisher equation is thus generally reduced to (see, e.g., Mishkin, 2001).

³ Note that Svensson differentiates between credibility in expectations and absolute credibility. See Svensson (1993) for further information.

⁴ The test is conducted by regressing the difference between yields from inflation-linked bonds and target-consistent real yields on the intercept: . See Bai and Perron (1998, 2003) for further information about multiple breakpoint tests.