“One of the most well-known problems with contemporary macroeconomics is that it leaves very little room for monetary illusions.” 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 estimate the market’s inflation expectations,” explains an analysis by DWS.
The chart illustrates this situation and shows the difference between the implied inflation rates for the next ten years – determined by comparing the yields on nominal and inflation-indexed ten-year bonds – for German federal bonds and US government bonds.
“Looking at this data suggests 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.” After inflation Now that Europe has been hit particularly hard, markets seem 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)?” asks the DWS analysis.
“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 measures that will be closely watched in the coming months, and are unlikely to be very high,” he explains. Ulrike Kastens, Senior Economist Europe at DWS.
“On the one hand, the market’s own inflation expectations have been quite volatile. On the other hand, inflation expectations are useful theoretical constructs for developing tractable models of how economies function. 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. “We trust that the ECB’s experienced economists know this, as they are aware that markets are not always as rational and well-informed as some economic commentators seem to believe,” he concludes.