Does inflation targeting track record matter for asset prices? Evidence from stock, bond, and foreign exchange markets

Abstract

Many central banks have adopted inflation targeting as their monetary policy frameworks since 1990. Yet, monetary authorities’ track records of managing inflation with respect to the stated policy objectives have varied significantly. This paper examines how inflation targeting track records affect asset prices within three common asset classes: stocks, bonds, and exchange rates. The analysis reveals heterogeneous and enduring effects of track records on financial markets. A stronger track record in inflation targeting leads to a more negative reaction from stock markets to inflationary pressures, with effects persisting for about four quarters. Additionally, the sensitivity of rising long-term sovereign bond yields to inflation diminishes for about three quarters as the track record improves. Moreover, credible inflation targeters are more likely to allow greater flexibility in exchange rates to deal with inflationary shocks. Consequently, credible inflation targeting track records produce desirable policy outcomes by reinforcing monetary policy transmission and saving fiscal space.