DP10124 | The Bond Market: An Inflation-Targeter's Best Friend

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Publication Date

14/09/2014

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Abstract

This paper explores the relationship between inflation and the existence of a publicly-traded, long-maturity, nominal, domestic-currency bond market. Bond holders suffer from inflation and could be a potent anti-inflationary force; I ask whether their presence is apparent empirically. I use a panel data approach, examining the difference in inflation before and after the introduction of a bond market. My primary focus is on countries with inflation targeting regimes, though I also examine countries with hard fixed exchange rates and other monetary regimes. Inflation-targeting countries with a bond market experience inflation approximately three to four percentage points lower than those without a bond market. This effect is economically and statistically significant; it is also insensitive to a variety of estimation strategies, including using political and fiscal instrumental variables. The existence of a bond market has little effect on inflation in other monetary regimes, as do indexed or foreign-denominated bonds.