Assessing Central Bank Commitment to Inflation Targeting: Evidence from Financial Market Expectations in India 
Gauging the success of a central bank’s inflation targeting regime by testing the degree to which inflation expectations become anchored can be problematic because exogenous macroeconomic shocks will also affect expectations. In addition, if the study examines an emerging-market economy, data on long-term inflation expectations will be lacking, making it difficult to assess the extent to which expectations have become anchored. Instead of focusing on realized inflation expectations in isolation, this paper combines a variety of survey forecasts with high-frequency financial market data to study how economic agents change their beliefs about the central bank’s response function after the adoption of inflation targeting. The paper applies this methodology to study India, a large emerging-market economy whose central bank, the Reserve Bank of India, adopted flexible inflation targeting in 2015.
Key Findings
- The market-perceived response by the Reserve Bank of India (RBI) to inflation grew substantially following the adoption of flexible inflation targeting (FIT).
- Interest rate expectations have responded markedly more to macroeconomic news surprises in the post-FIT period.
- FIT adoption in India coincided with a reduction in the mean of inflation forecasts, from a high of 8.6 percent in the pre-FIT period to 4.5 percent in the post-FIT period, which is close to the RBI’s inflation target of 4 percent.
- There has been a reduction in the variance in the forecasts of inflation and output growth in the time series as well as in the cross section of forecasters. These trends suggests that inflation expectations—at least in the short term—have stabilized since the adoption of FIT.
Implications
The paper’s findings indicate that India’s financial market believes that the Reserve Bank of India has become more responsive to inflation since its adoption of flexible inflation targeting. This result is consistent with the inflation-targeting goal of making a central bank more transparent and credible in its efforts to curb inflation.
Abstract
We propose a novel framework to gauge the credibility of central banks’ commitment to an inflation-targeting regime. Our framework combines survey data on macroeconomic forecasts with high-frequency financial market data to understand how inflation targeting makes economic agents change their perception about central bank decisions. Specifically, using the Reserve Bank of India’s adoption of inflation targeting in 2015 as a laboratory, we apply two different approaches to estimate a market-perceived monetary policy rule and analyze how it changed with the implementation of inflation targeting. Both approaches indicate that the market perceived a larger response to inflation in the monetary policy reaction function following the adoption of inflation targeting. This evidence suggests that the market viewed the shift to inflation targeting as a credible commitment by the Reserve Bank of India.