Inflation targeting, credibility, and non-linear Taylor rules

• Past deviations from inflation target feed back into today's interest rate setting.
• Loss in credibility forces central bankers to undertake larger interest rate steps.
• Illustrative New Keynesian model and empirical evidence for five IT countries.
• Extra response to past deviations from IT required to restore credibility.
• Asymmetric reaction with negative credibility losses dominating positive ones.

In this paper we systematically evaluate how central banks respond to deviations from the inflation target. We present a stylized New Keynesian model in which agents' inflation expectations are sensitive to deviations from the inflation target. To (re-) establish credibility, monetary policy under discretion sets higher interest rates today if average inflation exceeded the target in the past. Moreover, the central bank responds non-linearly to past inflation gaps. This is reflected in an additional term in the central bank's instrument rule, which we refer to as the ”credibility loss.” Augmenting a standard Taylor (1993) rule with the latter term, we provide empirical evidence for the interest rate response for a sample of five inflation targeting (IT) economies. We find, first, that past deviations from IT feed back into the reaction function and that this influence is economically meaningful. Deterioration in credibility (ceteris paribus) forces central bankers to undertake larger interest rate steps. Second, we detect an asymmetric reaction to positive and negative credibility losses, with the latter dominating the former.