Has the link between inflation uncertainty and interest rates changed after inflation targeting?

Purpose – The purpose of this paper is to establish a link between inflation uncertainty and interest rates for five inflation-targeting countries. Design/methodology/approach – The approach takes the form of a time-varying parameter model with a Generalized Autoregressive Conditional Heteroskedasticity (GARCH) specification, used to derive impulse uncertainty and structural uncertainty. Findings – This study attempts to establish a link between inflation uncertainty and interest rates for five inflation-targeting countries, i.e. Canada, Finland, Spain, Sweden, and the UK. Decomposing inflation uncertainty into two components – impulse and structural, a positive association was found between the expected inflation and interest rates. Structural uncertainty has a positive and significant effect on interest rates for some countries. It has also been found that the long-run effects of inflation on interest rates are less than unity for the post-inflation targeting period, which implies that in some respect the Central Bank has been successful in targeting inflation. This has allowed the Central Bank to employ a less restrictive monetary policy in an environment of a credible inflation-targeting strategy. Research limitations/implications – Exponential Generalized Autoregressive Conditional Heteroskedasticity (EGARCH) can be used instead of GARCH modelling. Originality/value – This is the first study that has tried to establish the link between different types of inflation uncertainty and interest rates for the inflation-targeting countries to see the effect of inflation targeting.