Eurozone policy-makers and researchers puzzled by trends in long-term inflation expectations

Some developments in long-term inflation expectations in the eurozone are puzzling the governing council of the European Central Bank (ECB), it has revealed – while some researchers at the institution are detecting unexpected and potentially significant patterns in the relevant data.

The ECB's governing council discussed changes in eurozone inflation expectations at length, the minutes from its September meeting show. Council members noted "market-based measures of inflation expectations had stopped increasing from the troughs reached at the beginning of the year and had declined somewhat since the last monetary policy meeting".

The council members also observed in the past 18 months that the link between current inflation and inflation expectations "appeared to have strengthened considerably". Evidence for both the eurozone and US "pointed to an increased correlation" between oil prices and inflation expectations, but the board found it "puzzling that current oil prices should strongly affect inflation so far into the future".

The stronger link between inflation expectations and current inflation "could be seen as a sign of an unanchoring of inflation expectations", the minutes noted. There was a "need for the Governing Council to "continue to conduct a broad-based analysis of all factors driving developments in inflation expectations", it added.

As António Armando Antunes notes in a recent working paper published by the Bank of Portugal, it is common to refer to long-term inflation expectations as "well-anchored". The phrase has two commonly used meanings. It can mean long-term inflation expectations are "hovering close to a commonly accepted target level". The phrase can also mean that "revisions of short-term inflation expectations should not per se imply revisions of long-term inflation expectations".

Antunes uses the second definition of "well-anchored", investigating whether changes in short-term inflation expectations have come to imply changes in long-term expectations. He utilises zero-coupon inflation-linked swap rates as a proxy for inflation expectations, using daily data from June 2004 to February 2015. Where long-term inflation rates are "anchored" and the central bank's price stability commitment is credible, Antunes argues, large revisions of short-term inflation expectations should not be correlated with similarly large revisions to the long-term expectations.

Since the middle of 2012, Antunes finds changes in short-term inflation expectations do now imply changes in the long-term expectations. Long-term inflation expectations, he argues, have now become "un-anchored" in the sense they appear to be strongly influenced by short-term expectations. Explaining the causality of this apparent relationship, Antunes says, is a matter for future research.

Another unexpected relationship in the data on long-term inflation expectations is the subject of a working paper published by the ECB. Matteo Ciccarelli and Juan Angel García find expectations of low long-term inflation in the eurozone are driving down expectations of long-term inflation in the US.

They also use inflation-linked swap rates as a proxy for expected inflation. These, they argue, are better proxies than break-even inflation rates computed from the yield spread between nominal and inflation-linked bonds.

The authors then construct a value-at-risk framework to model the long-term inflation expectations in the eurozone, the US and the UK. It is then possible, the authors argue, to distinguish between three types of shock to inflation expectations: idiosyncratic, affecting one economy but not the other; common, affecting all three; and spillovers, where a change in inflationary expectations in one area leads to a change in another area.

The factors behind inflation expectations in the US, the paper argues, are "quite different qualitatively and quantitatively" from those in the other regions. Some 30% of the changes in US inflation expectations for horizons beyond 12 months are driven by changes in eurozone long-term inflation expectations, the authors say. This relationship has been especially pronounced "since the late summer of 2014". Neither the eurozone nor the UK, the authors find, is affected by external inflation expectations, unlike the US.

This "somewhat puzzling spillover" is not something the authors can yet offer a causal explanation for. "The significant deterioration of the inflation outlook for the euro area since the summer of 2014 seems to be behind the presence of such a spillover effect", they argue. Their data, they add, helps understand "the puzzling decline in US medium-to-long (term) inflation expectations since August 2014".