Effects of fiscal credibility on inflation expectations: evidence from an emerging economy

Juan Camilo Anzoátegui-Zapata*

Juan Camilo Anzoátegui-Zapata

Affiliation: Universidad Autónoma Latinoamericana, Department of Economics, Medellín, Colombia

0000-0003-0588-1364

Correspondence
juan.anzoategui@unaula.edu.co

   

Juan Camilo Galvis-Ciro*

Juan Camilo Galvis-Ciro

Affiliation: Universidad Pontificia Bolivariana, Department of Economics, Medellin, Colombia

0000-0001-6680-275X

Article   |   Year:  2021   |   Pages:  125 - 148   |   Volume:  45   |   Issue:  1
Received:  July 16, 2020   |   Accepted:  November 10, 2020   |   Published online:  March 9, 2021

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https://doi.org/10.3326/pse.45.1.4

Abstract

1 Introduction

2003

2008

1981

Prompted by Sargent and Wallace (1981), some studies have sought to analyse the empirical and theoretical relationship between fiscal variables and inflation expectations in economies with inflation targets. First, Catao and Terrones (2003) find that deficit/GDP ratio downturns produce a significant reduction in inflation, with more effects in countries with high and persistent inflation. A similar result is reported by de Mendonça and Machado (2013). Celasun, Gelos and Prati (2004) as well as de Mendonça and Tostes (2015) note that fiscal balance recoveries reduce inflation expectations and observed inflation. Other studies, such as Cerisola and Gelos (2009), suggest that the inflation target, past inflation, and the primary fiscal balance can anchor inflation expectations in emerging economies. Nonetheless, Celasun, Gelos and Prati (2004) provide empirical evidence that inflation expectations have backward-looking components despite inflation target announcements. Similar results are reported by Araujo and Gaglianone (2010) and Gaglianone (2017), who highlight that inflation expectations show persistence. Other perspectives, for example, Berlemann and Elzemann (2006), find that inflation expectations are driven by presidential election results and the probability that leftist parties will come to power.

With central bank independence, the use of the inflation tax to achieve fiscal balance decreases (Minea and Tapsoba, 2014). Inflation targeting adoption leads to a government commitment to fiscal sustainability, which allows inflation expectations to be anchored in the central bank’s targets (see, for example, Cerisola and Gelos, 2009). With this perspective being borne in mind, the objective of this paper is empirical and consists of examining the effects of fiscal credibility on inflation expectations in the Colombian economy.

Colombia is a small emerging economy in Latin America that has made important efforts to achieve better economic stability through a coherent and prudent policy. In the Colombian case, the government adopted the inflation targeting at the end of 1999. Since 2000, the Central Bank of Colombia has improved its communication with markets by informing them about inflation targets and monetary policy management (Hamann, Hofstetter and Urrutia, 2014). Since 2003, the central bank has implemented sophisticated methodologies to monitor inflation expectations, fiscal deficit expectations and expected economic growth. In the fiscal management strand, the government established a decreasing goal for the fiscal deficit to convince markets about fiscal balance sustainability. As a result, after more than 10 years, the Colombian economy recovered its investment grade (Moody’s, 2014). In sum, Colombia is an interesting economic laboratory in which to analyse the interactions between monetary and fiscal policy (Ciro and de Mendonça, 2017).

2 Fiscal credibility and inflation targeting

2001

2005

2007

2001

2005

According to Gürkaynak, Levin and Swanson (2010), and Strohsal, Melnick and Nautz (2016), long-term inflation expectations should not respond to macroeconomic information when there is economic policy credibility. In Latin America, fiscal imbalances are a problem and cast doubt on monetary policy credibility. Fiscal balance is thus an indicator that must be carefully monitored to ensure the credibility of the inflation targets (Minea and Tapsoba, 2014). One strategy to resolve this problem resorts to the imposition of fiscal responsibility laws (Debrun, Hauner and Kumar, 2009; Lin and Ye, 2009; de Mendonça and da Silva, 2016). Following up on this idea, several studies have analysed the effect of fiscal targets or rules on inflation.

One strand of the literature has focused on measuring the effects of fiscal credibility in emerging economies under inflation targeting. This literature focuses on fiscal credibility indices to identify their effects on macroeconomic variables. In the case of Brazil, there are fiscal credibility indices on the deficit and public debt. The results of these studies show that fiscal credibility helps to anchor inflation expectations, reduces inflationary pressures and exchange rate pass-through on inflation, lowers disagreement in fiscal expectations and stabilizes market interest rates (de Mendonça and Tostes, 2015; de Mendonça and da Silva, 2016; Montes and Acar, 2018). According to de Mendonça and Machado (2013), an increase in fiscal credibility helps fixed rate bonds to be issued. Furthermore, credibility reduces the public debt indexed to market interest rates. Along this same line, the study by Montes and Souza (2020) suggests that greater fiscal credibility reduces sovereign risk.

Other studies have found similar results without using credibility indices. Thornton and Vasilakis (2019), using a sample of 61 low- and middle-income countries, find that countries that adopted transparent fiscal rules increased their fiscal credibility. Moreover, in the case of Indonesia, Kunkoro (2015) shows that rules for the fiscal deficit are a device to obtain fiscal credibility. Furthermore, credibility reduces deficit volatility and contributes to price stability. A similar result is reported for the case of Japan. According to Shirakawa (2012), when the government loses credibility regarding debt sustainability, inflation increases, boosting interest rates and increasing default probabilities. Similarly, for the case of the Czech Republic, Klyuev and Snudden (2011) demonstrate that public expectations about the government’s commitments to fiscal consolidation can improve its credibility. According to their results, fiscal credibility helps higher tax incomes and lower market interest rates to be achieved.

Other empirical studies measure credibility through financial markets’ reactions. In particular, Kandil and Morsy (2014) propose that fiscal credibility can be measured by the confidence that markets show in fiscal stimuli. According to their results, fiscal stimuli backed by international reserves generate greater credibility and increase the impact of stimuli related to public spending. In addition, credible market announcements help reduce the costs associated with loans and debt service.

2.1 The Colombian case

In 2000, the Central Bank of Colombia adopted an inflation targeting regime, and inflation rates have averaged 5% per year. Inflation targeting was adopted as a monetary policy response to anchor inflation expectations and increase fiscal restrictions (Gómez, 2006; López-Enciso, Vargas-Herrera and Rodríguez-Niño, 2016). To support the central bank, since 2004, the Colombian government has had debt controls and a medium-term fiscal framework that provides information about fiscal plans. In addition, in 2012 the Colombian government adopted a fiscal rule to progressively reduce the fiscal deficit. The objective of this rule is to achieve a primary fiscal deficit of less than 1% of GDP from 2022 (López-Enciso, Vargas-Herrera and Rodríguez-Niño, 2016). To achieve these targets, the government has carried out tax reforms to reduce the fiscal deficit. Despite all these fiscal commitments, reforms have been partial, with an average of one tax reform every two years. As a result, fiscal imbalances have not been resolved and fiscal credibility is low.

3 Methodology

2003

2007

2013

It is important to note that, in the case of emerging economies, fiscal deficits constantly put the fulfilment of the central bank’s objectives at risk. As a result, inflation expectation control is affected by fiscal credibility (Cerisola and Geros, 2009). This paper evaluates the effects of fiscal credibility on inflation expectations for the case of the Colombian economy based on central bank expectations surveys. These surveys average 40 participants among private banks, stockbrokers, pension funds, academics and international organizations. In the present study, inflation expectations are calculated as 1-year-ahead inflation forecasts of the participants surveyed. This information is available to the public through its central bank time series statistics system. Drawing on the information available, we present the inflation expectations for the 2004-2019 period in figure 1.

There are several challenges in measuring fiscal credibility because the government’s budget constraint involves several variables. According to de Mendonça and Machado (2013), fiscal credibility can be evaluated by public confidence in relation to the government’s ability to avoid the risk of default. Moreover, it is possible to affirm that there is fiscal credibility when there is a government commitment to the sustainability of public finances. As a result, there is credibility when the government does not use the inflation tax to fulfil its obligations (Hauner, Jonas and Kumar, 2007; Debrun and Kinda, 2017).

1994

2011

2017

DEFt = Gt + rDt-1 - Tt

(1)

where DEF_t is the overall fiscal deficit, G_t is the public expenditure, rDt–1 is the public debt interest, and Tt is the tax revenues. All the variables are defined as a percentage of the gross domestic product (GDP).

An essential point regarding the credibility of economic policy is public expectation. According to Cukierman and Meltzer (1986 ), credibility can be measured as the absolute value of the difference between the policymaker’s plans and the public’s beliefs about those plans. Moreover, as highlighted by Faust and Svensson (2001), credibility is negatively related to the distance between agents’ expectations and the achievements of the policy maker. Following Hauner, Jonas and Kumar (2007), fiscal credibility can be approximated by the difference between agents’ expectations of the fiscal deficit (E(DEF_t)) and the fiscal deficit achieved by the government (DEF_t). In other words, the greater the difference between the observed fiscal deficit and agents’ expectations, the less fiscal credibility there is because there is no convergence in agents’ beliefs. 

From that perspective, this paper uses a credibility loss indicator (CRED_LOSS) that considers the differences between the agents’ expectations about the fiscal deficit and the overall fiscal deficit observed (as an absolute value):

CRED_LOSSt = lE(DEFt) - DEFtl

(2)

where E(DEF) is agents’ expectations about the overall fiscal deficit and DEF is the overall fiscal deficit observed. The behaviour of both variables over time is presented in figure 2. The agents’ expectations regarding the overall fiscal deficit are extracted from the survey of the Central Bank of Colombia called “Macroeconomic Projections of Local and Foreign Analystsˮ. In this survey, the central bank asks brokers, commercial banks, pension funds, academic institutes, and rating agencies about the quarterly forecast of several macroeconomic variables, including the overall fiscal deficit. The quarterly data are available from 2004 (see appendix, table A1).

The behaviour of both variables (DEF and E(DEF)) over time is presented in figure 2 below. It is observed that from 2004 to 2008, expectations underestimated the observed fiscal deficit. Then, since the end of 2008, expectations began to grow and were located close to the fiscal deficit, surpassing it in 2010. Between 2010 and 2011, the government adopted a fiscal rule on the primary fiscal deficit, and from then on, expectations began to fall. From 2012 to 2016, there has been an increase in the observed fiscal deficit and, consequently, in expectations. This increase in variables peaked in 2016. Since then, there has been a drop in both the observed deficit and the expectations.

Figure 2

Fiscal deficit expectations and overall fiscal deficit observed in Colombia (in % of GDP)

DISPLAY Figure

Figure 3 shows the performance of fiscal credibility loss (CRED LOSS) from 2004 to 2019 in Colombia. The CRED LOSS indicator shows that there was uncertainty about fiscal policy in the 2006-2008 period. As a result, fiscal credibility loss was high in that period. Once expectations began to approach the observed deficit, the loss of credibility eased and reached a low of 0.14% in 2011Q1. After this, we began to observe an unstable behaviour of credibility loss. Despite this, the trend of the series shows that the loss of credibility was stable between 2012 and 2019. For the full period (2004-2019), the credibility loss was 0.9% on average.

Since the seminal contribution of Kydland and Prescott (1977), economic theory has assumed that an agent's expectations depend on the government’s credible commitment to an announced target. In other words, the expected path of the fiscal deficit matters for the formation of inflation expectations. In particular, when there is no commitment to fiscal equilibrium, government liabilities are ensured with seigniorage and the outcome is an increase in expected inflation (Sargent and Wallace, 1981).

Figure 3

Fiscal credibility loss in Colombia case (in %)

DISPLAY Figure

Credibility is the ability of policymakers to inspire confidence, and it can help form expectations. According to Mishkin (2007), inflation targeting in an environment of low fiscal credibility causes difficulties in managing inflation expectations and impacts the effectiveness of monetary policy. Hence, the baseline model considered in our empirical analysis is as follows: div>

E(πt) = β1 + β2CRED_LOSSt + α3Xt + εt

(3)

where E(π_t) is the annualized inflation expectations, CRED_LOSS_t is the fiscal policy credibility loss, X_t is a vector of explanatory variables, and ε_t is the residual term.

To observe an initial empirical relationship between inflation expectations and fiscal credibility loss, a scatter plot for both variables is presented in figure 4. The theoretical intuition of a positive relationship between both variables is confirmed. Thus, a better projection of the fiscal deficit can lead to a reduction in inflation expectations.

It is important to verify whether the public information available on macroeconomic and financial variables is taken into consideration by the agents. For this, it is useful to use the most recent data for inflation forecasts (Mankiw, Reis and Wolfers, 2003). Financial market volatility affects the performance of emerging economies and, indirectly, the formation of expectations (Kennedy and Palerm, 2014). For the Colombian case, the international economy outlook causes volatility in capital flows and the balance of payments that can impact inflation expectations. Therefore, we use behaviour of the S&P 500 stock market index (VIX_t-1) as our first explanatory variable for inflation expectations.

Figure 4

Inflation expectations and fiscal credibility loss in Colombia

DISPLAY Figure

Expectations depend on past information, and each agent interprets the available information in a different way (Roberts, 1997). In fact, the increase in inflation expectations can be attributed to backward-looking behaviour (Dornbusch and Fischer, 1993). Therefore, past inflation (π_t-1) is used as the second explanatory variable.

In emerging economies, movements in the exchange rate impact marginal costs and inflation forecasts (Celasun, Gelos and Prati, 2004). In particular, the Colombian economy has an important pass-through of the exchange rate to domestic inflation through its cost effects. Thus, as the third explanatory variable, the past exchange rate (e_t-1) is used.

According to the Neo-Keynesian Phillips Curve model, inflation expectations are related to the profit mark-up over costs. These mark-up changes are a function of the economic cycle (Woodford, 2003). Thus, we use GDP (y_t-1) as the fourth explanatory variable for inflation expectations.

On the basis of Okun’s law, it is possible to establish a relationship between output and the labour market. Accordingly, as an alternative measure of the economy, the past unemployment rate, is used as the fifth explanatory variable for inflation expectations (U_t-1).

In short, to analyse the effect of fiscal credibility on inflation expectations we used an explanatory variable associated with external risk (VIX_t-1), two measures associated with past prices (π_t-1, e_t-1) and two measures associated with economic performance (y_t-1, U_t-1). The past inflation expectations are also incorporated as an explanatory variable (E(π_t-1)) to capture some inertia in expectations. A dummy variable (D_t) is also added to capture the possible effect of the 2007-2008 subprime crisis. This dummy takes a value of 1 for the year 2008.¹ Thus, the possible combinations of these variables allow us to postulate the following models: 

E(πt) = α0 + α1 E(πt–1) + α2CRED_LOSSt + α3VIXt–1 + α4πt–1 + α5yt–1 + α6Dt+ εt0

(4)

E(πt) = α7 + α8 E(πt–1) + α9CRED_LOSSt + α10VIXt–1 + α11et–1 + α12yt–1 + α13Dt+ εt1

(5)

E(πt) = α14 + α15 E(πt–1) + α16CRED_LOSSt + α17VIXt–1 + α18πt–1 + α19Ut–1 + α20Dt+ εt2

(6)

E(πt) = α21 + α22 E(πt–1) + α23CRED_LOSSt + α24VIXt–1 + α25et–1 + α26Ut–1 + α27Dt+ εt3

(7)

Additionally, we estimate the full model with all the variables:

E(πt) = α28 + α29 E(πt–1) + α30CRED_LOSSt + α31VIXt–1 + α32πt–1 + α33yt–1 + α34et–1 + α35Ut–1 + α36Dt+ εt4

(8)

The period under consideration is from 2004-1 to 2019-4 (quarterly data). The choice of the period is due to data availability for the fiscal deficit expected, which are necessary to build the credibility index. See table A1 (appendix) for the sources of data and descriptions of all variables used in the study.

4 Empirical evidence

According to Engle and Granger (1981), it is possible to estimate the models proposed if there is a stationary combination in the series. Cointegration tests were performed for the proposed model. The choice of VAR lag and the inclusion of the deterministic components of the cointegration vector was made on the basis of the Schwarz criterion (Harris, 1995). The cointegration test proposed by Johansen (1991) based on the significance of the estimated eigenvalues indicates the existence of a cointegration vector in the models (see table A3, appendix). Thus, the models were estimated with the series in levels without problems of spurious regressions.

The equations above were estimated using Ordinary Least Squares (OLS) and Generalized Method of Moments (GMM). In the case of the models estimated with OLS, tests of autocorrelation (LM test) and heteroscedasticity (Breuch-Pagan-Godfrey test) were applied to validate the estimates. According to Hansen (1982), the main reason for using the GMM method is because endogeneity and autocorrelation problems may exist, which will invalidate the OLS estimates. Given this, in GMM estimates the instruments chosen were lagged for at least one period. According to Wooldridge (2001), to obtain efficient estimations with the GMM method, overidentification restrictions are necessary. In this sense, the J test was applied. The estimations of equations (4)-(8) are presented in table 1.

The results of the estimates show the expected sign. The parameter associated with past expectations (E(π_t-1)) is positive and significant. Inflation expectations present some inertia with the expectations of the past period. That is, there is some evidence that expectations are adaptive, and agents learn slowly. A similar result is reported by Mankiw, Reis and Wolfers (2003).

The coefficient associated with fiscal credibility loss (CRED LOSS) is positive and statistically significant in all models. The theoretical intuition that the fiscal policy stance has been important in shaping inflation expectations is confirmed. Thus, when confidence grows about the government’s commitment to fiscal sustainability, the expected inflation decreases. The evidence supports the theoretical perspective of Sargent and Wallace (1981) and the findings confirm that the lower uncertainty about the expected fiscal deficit and, therefore, greater fiscal credibility matter for inflation expectations. Similar results are reported by Kuncoro (2015), Cerisola and Geros (2009), and Celasun, Gelos and Prati (2004).

With the results in table 1, we calculated that an increase of one unit in CRED LOSS can boost inflation expectations in a range that varies between 9.15% and 12%. For example, if inflation expectations are at 3%, an increase of one unit in CRED LOSS can increase expectations to a range between 3.27% and 3.36%.² Therefore, according to Celasun, Gelos and Prati (2004), the findings show that building fiscal credibility is relevant to anchoring inflation expectations.

On the other hand, in relation to the coefficient associated with past external risk (VIX_t-1), the estimations show that the parameter is not significant. This finding suggests that increases in global financial uncertainty do not increase inflation expectations in Colombia. The importance of past inflation (π_t-1) for the formation of expectations is also significant. Using the results of Bomfim and Rudebusch (2000), it is possible to affirm that since inflation expectations respond to past inflation, monetary policy in Colombia is not fully credible. According to the results, the coefficient associated with past inflation varies between 9.79% and 16.77%. Therefore, if past inflation increases one unit and expectations are at 3%, the result is that expectations can move to between 3.29% and 3.50%. However, this result suggests that inflationary inertia has fallen in Colombia and expectations are better anchored. Some empirical studies highlight similar results for emerging economies that have adopted inflation targeting (see, Celasun, Gelos and Prati, 2004; Bevilaqua, Mesquita and Minella, 2008; Cerisola and Geros, 2009; Gaglianone, 2017).

In the case of the parameter associated with the exchange rate (e_t-1), the coefficient is positive and significant. Accordingly, depreciation tends to increase inflation expectations in the Colombian economy. This result indirectly confirms the hypothesis that firm costs are tied to the behaviour of the exchange rate due to its effects on imported inputs. However, in the estimated models, the estimated parameter tends toward zero, which indicates that very high devaluations (above 1,000 Colombian pesos) are necessary for expectations to increase by more than one percentage point. Similar evidence has been reported by Bevilaqua, Mesquita and Minella (2008), Araujo and Gaglianone (2010), and Gaglianone (2017).

The coefficient associated with the past behaviour of the economy (y_t-1) is positive and statistically significant. That is, inflation expectations fall in recessions and rise in economic booms. In the case of the coefficient associated with the past unemployment rate (U_t-1), the econometric result shows that it is also positive and significant. According to Mankiw, Reis and Wolfers (2003), inflation expectations are high during periods of high unemployment, suggesting a belated overreaction of expectations to the labour market situation. With the results of table 1, an increase in the past unemployment rate leads to increases in inflation expectations in a range between 0.04 and 0.12 percentage points. The results confirm the theoretical perspective of the Kydland and Prescott (1977) dynamic incoherence models. These models indicate that increases in unemployment can be the result of attempts to surprise agents with unexpected inflation. Expansive policy can lead to short-term gains in terms of product increases, as the Phillips curve points out. However, according to the findings of Ireland (1999), in the long term, the result is a balance in which the inertia of inflation expectations is positively cointegrated with the unemployment rate. Thus, the evidence suggests that during the period of analysis, there was no trade-off between inflation expectations, inflation and unemployment. Finally, the coefficient associated with the dummy variable (D_t) is positive and significant in almost all models. In other words, the subprime crisis raised inflation expectations in Colombia.

4.1 OLS recursive estimates

5 Conclusions

Appendix

Notes

* The authors would like to thank two anonymous referees for helpful comments on earlier versions of this paper. Any remaining errors are the sole responsibility of the authors.

¹ Beside the presented models, we also estimated models with output gap replacing GDP as well as by including more lags of inflation. The obtained results were not statistically significant and are available upon request.

² CRED LOSS is calculated in the units in which the fiscal deficit is measured as percentage of GDP. Therefore, an increase of one unit in CRED LOSS means that deficit expectations are 1% (% of GDP) above the observed deficit.

Disclosure statement

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