Inflation Targets and the Yield Curve: New Zealand and Australia vs. The Us

Abstract

This study considers the role of the yield curve as a predictor of future interest rates, inflation rates and economic activity for New Zealand. To provide a basis for comparison, data from Australia and the US are also considered. Many studies have shown a strong empirical link between the spread of long-term and short-term interest rates, otherwise called the yield curve, and key economic indicators such the rate of inflation, short-term interest rates, and GDP growth. There has been very little effort, however, at ascertaining whether these links are affected by the choice of monetary regimes, especially of the inflation targeting variety. Both Australia and New Zealand have been targeting inflation for a number of years but the New Zealand variety of inflation targeting is considered to be far stricter than the Australian version. The US, which clearly has an important influence on both the New Zealand and Australian economies, does not formally target inflation.

The empirical evidence, covering mainly quarterly data from 1985, reveals several interesting findings. First, at horizons of two years or less, the term structure of New Zealand interest rates provides useful information about the future course of short-term interest rates. Paralleling other such studies, the yield curve does not predict future short-term interest rates well in either Australia or US data. However, when there are large policy "shocks" from abroad, such as the US Fed's moves to sharply tighten monetary policy in 1994, these have a significant impact on both New Zealand and Australia. The ability of the yield curve to predict future inflation is critically dependent upon the choice of price indexes. Thus, for example, the Reserve Bank of New Zealand's preferred index, CPI ex-credit costs, is not well predicted by the yield curve. However, we argue that this result is consistent with a credible inflation targeting regime. The reason is that changes in the spread between long-term and short-term interest rates signal changes in the real interest rate in a credible inflation targeting regime. Finally, it is found that the yield curve is a good predictor of future GDP growth in the very short-run (one year or less) but that the relationship is sensitive to whether economic growth is accelerating or decelerating.

Overall, the results suggest important differences in the predictive performance of the yield curve between inflation and non-inflation targeting regimes worthy of further study.

Note: This is a description of the paper and is not the actual abstract.

JEL Classification: E43, C22, C23, C32, C33