Has the link between inflation uncertainty and interest rates changed after inflation targeting?

Abstract

PurposeThe purpose of this paper is to establish a link between inflation uncertainty and interest rates for five inflation‐targeting countries.Design/methodology/approachThe approach takes the form of a time‐varying parameter model with a Generalized Autoregressive Conditional Heteroskedasticity (GARCH) specification, used to derive impulse uncertainty and structural uncertainty.FindingsThis study attempts to establish a link between inflation uncertainty and interest rates for five inflation‐targeting countries, i.e. Canada, Finland, Spain, Sweden, and the UK. Decomposing inflation uncertainty into two components – impulse and structural, a positive association was found between the expected inflation and interest rates. Structural uncertainty has a positive and significant effect on interest rates for some countries. It has also been found that the long‐run effects of inflation on interest rates are less than unity for the post‐inflation targeting period, which implies that in some respect the Central Bank has been successful in targeting inflation. This has allowed the Central Bank to employ a less restrictive monetary policy in an environment of a credible inflation‐targeting strategy.Research limitations/implicationsExponential Generalized Autoregressive Conditional Heteroskedasticity (EGARCH) can be used instead of GARCH modelling.Originality/valueThis is the first study that has tried to establish the link between different types of inflation uncertainty and interest rates for the inflation‐targeting countries to see the effect of inflation targeting.