Inflation Risk Premiums and Inflation Targeting: An Empirical Measure of Credibility

In this paper we attempt to empirically establish credibility of inflation targets set by the Bank of Canada, using inflation risk premiums on Government of Canada nominal marketable bonds. Explanatory power of the distance of observed inflation from target over inflation risk premiums is interpreted as degree of credibility. We use diagrammatic framework, and develop simple analytical model to demonstrate these ideas. We find that the distance from target is statistically significant, suggesting high degree of credibility over the past decade, and that inflation close to upper or lower bounds of the inflation target range is associated with lower inflation risk premiums than inflation on target