In modern macroeconomics, the anchoring of inflation expectations is crucial for central bank credibility. When investors trust that inflation will meet policy targets over the long term, central banks can effectively influence economic activity by adjusting interest rates according to the Taylor principle. However, when long-term inflation expectations fluctuate, doubts may arise about a central bank’s capacity to manage inflation, potentially undermining the effectiveness of its policies.
This issue has gained attention in Europe, where the European Central Bank (ECB) is responsible for maintaining inflation stability at a target rate of 2%.
The ECB’s aggressive monetary policy measures, including interest rate hikes and quantitative tightening, successfully lowered inflation to 2.5% by June 2024, after peaking at a concerning 10.7% in October 2022 due to post-pandemic supply chain disruptions and rising energy costs. Nonetheless, questions remain: has the ECB succeeded in sustaining stable inflation expectations, or have recent economic challenges diminished its credibility?
Table of Contents:
Examining the impacts on inflation expectations
This article provides an overview of an award-winning thesis by the author, who received the top prize in the 2024 CFA Society Belgium Master Theses Awards. The research explores how inflation expectations in the euro area, as indicated by inflation-linked swap (ILS) rates, responded to monetary policy changes from 2013 to 2024. This timeframe encompasses two significant periods: the years before the COVID-19 pandemic, marked by persistently low inflation, and the subsequent inflationary surge that followed.
Understanding the reaction of investors
The responses of investors during this period offer vital insights into whether the ECB’s strategies, such as forward guidance, interest rate modifications, and quantitative easing (QE), have either strengthened or weakened market confidence in its inflation objectives. While earlier studies have concentrated on immediate market reactions to policy announcements, this research introduces a novel perspective.
The findings indicate that the ECB should proceed with caution when utilizing forward guidance. While it can effectively shape market expectations, poorly designed guidance may lead to Delphic shocks, which could ultimately undermine policy goals. In contrast, standard interest rate adjustments and QE appear to have a more predictable effect on inflation expectations. Notably, overreacting with excessively tight policies is unnecessary, as the data suggests that long-term expectations remain anchored, indicating that inflation can be steered toward the target without stifling economic growth.
Key insights from the analysis
The analysis was organized into three main components, revealing significant trends. First, across various models, inflation expectations for five to ten years remained largely stable despite policy surprises. Even during the heightened volatility observed from 2022 to 2023, investors did not significantly change their long-term inflation outlook for the euro area, suggesting that expectations have not become de-anchored. This strongly implies that, despite the ECB’s delayed response to rising prices, its 2% target retains credibility.
Implications for market participants
For participants in the financial markets, these findings lead to two critical conclusions. Firstly, the recent surge in inflation post-COVID has not eroded confidence in the ECB’s long-term inflation expectations. As a result, the ECB’s 2% inflation target is perceived as credible, indicating that the central bank may not need to implement excessively stringent monetary policies to realign inflation with its target. Secondly, this stability fosters greater investor confidence in long-term market signals, enabling them to avoid overreacting to transient inflation fluctuations.
The dynamics of inflation expectations and the actions of the ECB underscore the delicate balance central banks must maintain to uphold their credibility. As the economic landscape evolves, understanding these relationships will be essential for both policymakers and investors alike.
