The stability of inflation expectations is crucial in modern macroeconomic theory, serving as a key indicator of a central bank’s reliability. When market participants anticipate inflation will remain near a specified target over the long term, central banks can effectively manage economic fluctuations by adjusting interest rates according to the Taylor principle. However, wavering long-term expectations can foster skepticism about a central bank’s capability or willingness to control inflation, thus undermining the effectiveness of its policies.
This concern has gained particular relevance in Europe. The primary goal of the European Central Bank (ECB) is to maintain stable inflation at a target of 2%. Following rising inflation rates, which reached a peak of 10.7% in October 2022 due to post-pandemic supply chain disruptions and soaring energy costs, the ECB instituted a series of aggressive monetary tightening measures. By June 2024, these initiatives succeeded in lowering inflation to 2.5%. Nevertheless, this figure still exceeds the ECB’s target, raising questions among market analysts and policymakers about whether the ECB has effectively anchored inflation expectations or if recent fluctuations have compromised its credibility.
Analyzing inflation expectations in the euro area
This article draws on a comprehensive thesis, awarded first place at the 2024 CFA Society Belgium Master Theses Awards, to explore the dynamics of euro-area inflation expectations. The analysis spans from 2013 to 2024, covering two crucial periods: a pre-COVID phase characterized by consistently low inflation and a post-COVID period marked by sharp increases. By examining how inflation-linked swap (ILS) rates responded to changes in monetary policy during this timeframe, valuable insights emerge regarding the effectiveness of the ECB’s strategies, including forward guidance, interest rate adjustments, and quantitative easing (QE) in fostering or undermining confidence in its inflation objectives.
Market reactions to monetary policy changes
Previous studies have primarily focused on immediate market reactions to monetary policy announcements (for example, Bernanke & Kuttner, 2005; Gurkaynak, Sack & Swanson, 2005; Altavilla et al., 2019). However, our study reveals novel findings: the ECB should exercise caution when employing forward guidance. While such guidance can effectively shape market expectations, improper calibration may lead to Delphic shocks that disrupt policy objectives. In contrast, traditional rate adjustments and QE tend to influence expectations in a more predictable manner. Notably, the analysis indicates that an excessively restrictive policy approach is unnecessary, as the stability of long-term expectations suggests inflation can be guided back to target levels without hindering economic growth.
Key findings from the analysis
Our analysis is divided into three sections: across all models considered, inflation expectations for the five to ten-year horizon remained largely unaffected by policy surprises. Even during the tumultuous period from 2022 to 2023, investors did not significantly alter their long-term outlook for euro-area inflation, indicating a sustained confidence. This finding robustly suggests that, despite the ECB’s initial slow response to rising prices, its 2% inflation target retains credibility.
For market participants, this study presents two critical implications:
- Firstly, even amid the recent surge in post-COVID inflation, announcements regarding monetary policy did not lead to a significant loss of long-term inflation expectations in the euro area.
- Secondly, the credibility of the ECB’s 2% inflation target indicates there is no immediate need for overly stringent monetary policies to guide inflation back to target levels. Investors can thus trust in the stability of long-term market signals and should avoid overreacting to transient inflation fluctuations.
The findings suggest a resilient anchoring of inflation expectations, indicating that the ECB’s strategies have been effective in maintaining credibility despite recent economic challenges.
