In the field of modern macroeconomics, the stability of inflation expectations plays a crucial role in shaping central bank policies. A key component is the belief among investors that inflation rates will remain near predetermined targets over extended periods. This conviction enables central banks to effectively influence economic conditions by adjusting interest rates, consistent with the Taylor principle. However, when long-term inflation expectations waver, it raises concerns about the central bank’s ability to control inflation, potentially diminishing the effectiveness of its policy interventions.
This issue has become particularly pressing in Europe, where the European Central Bank (ECB) aims to maintain a medium-term inflation target of 2%. In response to rising inflation, which peaked at 10.7% in October 2022 due to post-pandemic supply chain disruptions and escalating energy costs, the ECB enacted stringent monetary policies, including aggressive interest rate hikes and quantitative tightening. By June 2024, these measures successfully reduced inflation to 2.5%. However, this figure still exceeds the ECB’s target, raising questions about the bank’s ability to anchor inflation expectations and whether its credibility has been compromised by recent challenges.
Examining the ECB’s credibility and inflation expectations
This article expands upon an award-winning thesis by the author, who secured first place in the 2024 CFA Society Belgium’s Master Theses Awards. The research investigates the response of inflation expectations in the euro area, measured by inflation-linked swap (ILS) rates, to various monetary policy shocks from 2013 to 2024. This period encompasses two critical phases: the low-inflation era preceding the COVID-19 pandemic and the subsequent inflation surge that ensued. By analyzing investor reactions during these different contexts, we can evaluate whether the ECB’s strategies, including forward guidance, interest rate changes, and quantitative easing, have strengthened or weakened confidence in its inflation objectives.
Key findings on monetary policy impacts
While previous studies have concentrated on high-frequency market responses surrounding policy announcements—such as those conducted by Bernanke and Kuttner (2005) and Gurkaynak et al. (2005)—this research provides new insights. The findings indicate that the ECB should exercise caution in its use of forward guidance. Although it has the potential to effectively shape market sentiments, poorly designed guidance may lead to Delphic shocks that could undermine policy intentions. Conversely, conventional interest rate adjustments and quantitative easing appear to have a more predictable effect on expectations. Notably, it may not be necessary for the ECB to implement excessively stringent policies, as the anchoring of long-term inflation expectations suggests that inflation can be guided back to target without hindering economic growth.
Investor reactions during volatile periods
The analysis is divided into three sections, each offering a comprehensive view of investor sentiment regarding inflation expectations. Data across various models reveals that inflation expectations for the five-to-ten-year horizon remained largely unaffected by policy surprises. Even during the significant market fluctuations between 2022 and 2023, investors did not significantly alter their long-term outlook on euro-area inflation, indicating a sustained anchoring. This serves as compelling evidence that, despite the ECB’s delayed response to rising prices, its 2% inflation target retains credibility.
Implications for market participants
For market participants, these findings carry important implications. Firstly, even amid the recent inflation surge post-COVID, announcements regarding monetary policy did not lead to a significant de-anchoring of long-term inflation expectations in the euro region. This suggests that the ECB’s inflation target of 2% remains credible in the eyes of financial markets. Consequently, the ECB may not need to resort to excessively tight monetary policies to realign inflation with its target. Secondly, this stability allows investors to place greater trust in long-term market indicators, reducing the need to overreact to short-term inflation fluctuations.