A commodity-price test for central bank credibility: The case of the bank of Canada

In the early 1990s, the Bank of Canada adopted an inflation-targeting framework for monetary policy. In principle, the framework credibly commits a central bank to price stability and, thus, renders transitory the consequences of otherwise-self-fulfilling and persistent shocks to expected inflation. The Bank of Canada adopted this framework to solve a time-inconsistency problem with which it dealt for much of the twentieth century; thus, the Bank of Canada sought credibility. My objective in this paper is to test whether or not the Bank of Canada achieved the credibility it sought. My methodology is to test indirectly how the real interest rate responded to inflation surprises—actual minus expected inflation at a moment in time—before and after the Bank of Canada adopted its inflation-targeting framework. I infer these responses from the behaviors of commodity and foreign-currency prices. Because commodities and foreign currencies are flexible-price goods in an otherwise rigid-price world, the prices of these assets should, in principle, unambiguously reveal market perceptions of the stance of monetary policy; the reason why draws on the relationships between currency prices and interest rates in Dornbusch (1976). As a robustness check of my methodology, I test US commodity and foreign-exchange market responses to inflation surprises in the late 1970s and early 1980s, when the so-called Volcker experiment afforded the Federal Reserve System the credibility it then sought (Frankel and Hardouvelis, 1985). My results indicate that the shift in Canadian monetary policy earned the Bank of Canada the credibility it sought (and, prior to the early 1990s, it lacked). Specifically, after the Bank of Canada adopted its inflation-targeting policy, but not before, commodity and foreign-currency prices responded negatively to inflation surprises. Thus, shortly after the bank adopted the policy, commodity and foreign-currency prices moved in ways that suggested positive [negative] core-inflation surprises led the market to expect a monetary contraction [expansion] that would temporarily increase [decrease] the real interest rate. This result suggests commodity and foreign-currency markets reasoned the Bank of Canada was credibly committed to low and stable inflation.