Interpreting recent developments in market based indicators of longer term inflation expectations

Private sector inflation expectations are a key component of a broad range of indicators that the ECB considers when determining the appropriate monetary policy stance for achieving its price stability objective. Inflation expectations can not only affect inflation itself through the wage and price-setting processes, but also serve as a useful cross-check on the ECB’s and the Eurosystem’s own projections. This article focuses on market-based measures of longer-term inflation expectations, which are timely indicators derived from the prices of instruments that are traded in financial markets and linked to future inflation outcomes. It reviews recent developments in the information that can be extracted from different types of market-based indicator, starting from the period leading up to the ECB’s announcement of its expanded asset purchase programme (APP). The fall in market-based indicators of longer-term inflation expectations between 2014 and mid-2016 was consistent across major jurisdictions, possibly reflecting global concerns about weak aggregate demand and associated disinflationary pressures. Their subsequent recovery has been driven by a partial dissipation of these concerns and, in particular, a significant improvement in the euro area macroeconomic environment. The lion’s share of the movement in longer-term inflation expectations over the past few years has stemmed from the inflation risk component of these indicators, suggesting that the balance of risks to the inflation outlook has been one of the main drivers. Indeed, information extracted from the prices of inflation options implies that the risk-neutral probability of deflation increased noticeably in late 2014 and early 2015, before declining more recently. JEL Classification: E44, G12, G01