The Effect of Recent ECB Policy on Inflation Expectations
By Alejandro Badel, Economist, and Joseph McGillicuddy, Research Analyst
Inflation expectations and realized inflation have trended down in the eurozone for several months. In fact, Germany’s inflation rate turned negative in January for the first time since the financial crisis. Also, some measures of inflation expectations have been declining since April 2013 for countries such as Germany, France and Italy. This has led the European Central Bank (ECB) to consider several policy alternatives including the lending facility established in mid-2014.
However, market commentators and policymakers have viewed those efforts as ineffective for increasing inflation expectations and actual inflation. Thus, there has been ample talk of a quantitative easing (QE) program for the eurozone. On Jan. 14, the European Court of Justice (ECJ) endorsed a bond-buying program. On Jan. 22, the ECB announced it would acquire public and private assets at a rate of 60 billion euros per month until at least September 2016, starting in March of this year.
How Have Inflation Expectations Reacted?
Breakeven inflation expectations are defined as the additional yield provided by nominal debt over the yield on inflation-indexed debt. The figures below show breakeven inflation expectations implied by sovereign bonds from the eurozone since the last days of 2014.
Both figures show a substantial trend break around the ECJ court ruling. Ten-year breakeven inflation expectations rose by roughly 30 basis points between mid-January and Jan. 22. Breakeven inflation expectations over shorter horizons rose even more (roughly 40 basis points) during the same period. However, breakeven inflation expectations fell abruptly during the week following the ECB policy announcement. Finally, during the past week, breakeven rates have nearly rebounded to their Jan. 22 levels.
This time, something is different. Compared to the announcement of the lending facility in mid-2014, the reaction to the QE announcement is loud and clear. The timing and the speed of the reversal after Jan. 22 suggests there was something surprising about the policy with respect to market expectations. The announcement of the ECB’s QE program seems to have shifted the level of inflation expectations, which have recovered during the past week.