Finance and Economics Discussion Series

Lowering the Anchor: How the Bank of England's Inflation-Targeting Policies have Shaped Inflation Expectations and Perceptions of Inflation Risk

Meredith J. Beechey
2008-44

Abstract: Inflation targeting as practiced by the Bank of England has undergone several changes since its adoption in 1992, including redefinition of the goal, measures to increase transparency and the granting of independence to the central bank. These changes are likely to have affected long-run inflation expectations and perceptions of future inflation risk. To that end, this paper estimates a no-arbitrage, affine, factor model of the term structure of inflation compensation in the United Kingdom. The model yields time series of expected inflation and inflation risk premia at short and long horizons estimated in a theoretically consistent manner. The results reveal that long-run inflation expectations drifted down slowly during the first five years of inflation targeting, but inflation risk premia moved down abruptly only once the Bank of England was granted independence. This event, which arguably signalled more credible commitment by the central bank to its inflation anchor, appears to have been more important in shaping inflation expectations and perceptions of inflation risk than changes in the definition of the target or measures to increase transparency.

Keywords: Inflation targeting, inflation compensation, term structure, factor model, risk premia