Indexed bonds and inflation expectations in the euro area

In recent years, the issuance of inflation-indexed bonds has grown strongly in the main debt markets. The fundamental characteristic of these bonds is that their yield is protected against inflation, since their holders are compensated in both coupon payments and in the repayment of principal (upon maturity) for the loss of purchasing power attributable to actual inflation. Although the origin of indexed debt and its theoretical rationale go back more than two hundred years, the essential development of this market is very recent and has coincided with a setting of historically relatively low inflation rates in most of the industrialised countries. This is surprising when considered from the investor’s standpoint, since the main characteristic of these instruments is that they protect the yield on the investment against inflation. From the viewpoint of the issuer, however, the current setting is clearly more favourable. One of the channels through which monetary policy may have a bearing on price developments is through its effect on long-term inflation expectations. If economic agents give credibility to the capacity and commitment of the central bank to maintain price stability, price and wage setting mechanisms will contribute to the attainment of the inflation target. Hence the importance of long-term inflation expectations remaining firmly anchored, and the need to monitor their developments very closely. The purpose of this article is twofold. First, it describes the evolution of the indexed debt market in the euro area and its main characteristics; and, second, it analyses the possibilities offered by these instruments for measuring changes in long-term inflation expectations. In particular, a detailed analysis of the break-even inflation rate (BEIR), which is estimated using the yield on inflation-linked bonds, is presented. Currently, the bulletins of the most important central banks, as well as a large number of international public institutions and many financial institutions, comment regularly on these movements. This article may, therefore, be considered a practical guide to the interpretation of such information. To this end, the second section presents an overview of the main indexed-debt markets and discusses, in particular, the development of the indexed-bond market in the euro area. Thereafter, the use of these instruments in the construction of inflation expectations indicators is analysed, with an explanation of the various possibilities that they offer, as well as their advantages and disadvantages. Finally, some brief conclusions are drawn.