The stability of inflation expectations is a critical element in macroeconomic theory, particularly regarding the credibility of central banks. When market participants expect inflation to remain near a predetermined target over time, central banks can effectively influence economic activity by adjusting interest rates according to the Taylor principle. However, a shift in long-term expectations toward instability can lead to skepticism about a central bank’s ability or willingness to manage inflation, undermining the effectiveness of its policy interventions.
This issue has gained significant attention in the European context. The primary objective of the European Central Bank (ECB) is to maintain inflation stability at a target rate of 2%. Following a period of substantial monetary tightening, including significant interest rate hikes and a strategy of quantitative tightening, inflation levels were reduced to 2.5% by June 2024, after peaking at 10.7% in October 2022. This spike was largely due to supply chain disruptions and rising energy prices following the COVID-19 pandemic. Nevertheless, this figure still exceeds the ECB’s target, raising questions about whether the bank has succeeded in anchoring inflation expectations or if recent challenges have compromised its credibility.
Investigating inflation expectations in the euro area
This article is based on an award-winning thesis by the author, who earned first place at the 2024 CFA Society Belgium’s Master Theses Awards. It aims to address the pressing question of how inflation expectations in the euro area, as measured through inflation-linked swap (ILS) rates, reacted to various monetary policy shocks from 2013 to 2024. This timeframe includes two crucial periods: the years leading up to COVID-19, marked by persistently low inflation, and the subsequent inflation surge following the pandemic. Analyzing market reactions during these times provides valuable insights into whether the ECB’s forward guidance, interest rate changes, and quantitative easing (QE) measures have strengthened or weakened trust in its inflation targets.
Market responses and their implications
While previous studies have focused on high-frequency market reactions to policy announcements, this analysis presents new findings. The results suggest that the ECB should exercise caution regarding the use of forward guidance. While effective in shaping market expectations, imprecisely calibrated guidance may result in Delphic shocks that could disrupt policy goals. In contrast, traditional interest rate adjustments and quantitative easing have proven to influence expectations in a more predictable manner. Importantly, excessive tightening of policies is unnecessary; the stability of long-term expectations indicates that inflation can be guided back to the target without hindering growth.
Key findings and market perspectives
The analysis unfolds in three sections, revealing consistent findings across various models. It was observed that five- to ten-year inflation expectations remained largely unaffected by policy surprises. Even amid heightened volatility from 2022 to 2023, investors did not adjust their long-term inflation outlook for the euro area in a way that suggests a loss of anchoring. This strongly supports the idea that, despite the ECB’s delayed intervention in response to rising prices, its 2% inflation target maintains credibility.
For market participants, the implications of these findings are twofold. First, during the post-COVID period of elevated inflation, monetary policy announcements have not led to a significant de-anchoring of long-term inflation expectations in the euro area. Consequently, the ECB’s 2% inflation target continues to be regarded as credible by financial markets. This suggests that the central bank may not need to implement excessively restrictive monetary policies to guide inflation back on track. Second, this stability in expectations enables investors to have greater confidence in long-term market signals, helping them avoid overreacting to transient inflation fluctuations.
