Ulrike Kastens, Economist Europe at DWS | One of the most well-known problems with contemporary macroeconomics is that it leaves little room for monetary illusions (1). Supposedly people are rational enough and well-informed enough to always see through the veil of inflation immediately and accurately. Some prices and wages might be a little tough at first. However, logic dictates that nominal amounts should be easily and accurately adjusted to inflation expectations, assuming wages and prices have the opportunity to adjust. In the meantime, it will be the markets that accurately price this behavior. This in turn means that the prices of financial assets, such as inflation-indexed bond contracts, can be used to measure the market’s inflation expectations.
Our Chart of the Week illustrates this situation, showing the spread between implied inflation rates over the next 10 years – determined by comparing nominal and inflation-indexed 10-year bond yields – for German Bunds and US Treasury bonds. Looking at this data, we can conclude that over the last decade, markets have assumed that US inflation would be higher than German inflation and that it could be viewed as an approximation of European inflation. Now that inflation has hit Europe particularly hard, markets appear to be expecting the Old Continent to experience higher inflation rates for a decade. Does this mean that the European Central Bank (ECB) has a lot of work to do to defend its credibility, perhaps even more than the US Federal Reserve (Fed)?
We wouldn’t go that far. “The ECB has many good reasons to defend itself against inflation. Following the latest rate hike, we expect them to remain at current high levels, probably for a longer period depending on available data. But market-derived inflation expectations are just one of many metrics that will be closely watched in the coming months, and are unlikely to be very high,” explains Ulrike Kastens, Senior Economist Europe at DWS.
On the one hand, the market’s own inflation expectations have been quite volatile.(2) On the other hand, inflation expectations are useful theoretical constructs for developing tractable models of the functioning of economies. Postulating them, however, is no substitute for observing how wages and prices are set or how real-world expectations arise in a particular country. The way indexed bond contracts are structured and indexed, not to mention market liquidity, differs not only between the US and Germany, but even within the Eurozone. The different countries of the common euro also experience quite different dynamics, which makes transatlantic comparisons of small differences between the USA and one country, certainly important, meaningless for monetary policy. Finally, inflation itself is surprisingly difficult to measure(3). We trust the ECB’s experienced economists know this, as we recognize that markets are not always as rational and well-informed as some economic commentators seem to believe.
Inflation expectations for Germany now exceed the bond market expectations for the USA
