Can inflation expectations derail monetary policy?

In 2022, inflation reached 8.4 % in the euro area, a level not seen since the creation of the currency union in 1999. Against this backdrop, one may well wonder whether economic agents still expect an inflation rate close to the 2 % target set by the European Central Bank (ECB). While this question tends to be answered in the affirmative, there are a number of points worthy of attention.

Anchoring inflation expectations to stabilise prices

With the rise of inflation following the COVID-19 pandemic and Russia’s invasion of Ukraine, the issue of “anchoring” inflation expectations, that is, keeping inflation expectations close to the central bank’s target, has become increasingly important.

Inflation expectations anchored to the central bank’s target contribute to a stable economic environment. When inflation expectations rise, the main risk is of inflation rising as well due to an anticipatory effect: if consumers expect higher prices tomorrow, they will run to the shops today! A vicious circle is created when higher current inflation leads to more elevated inflation expectations.

That’s why central banks watch out for any deviation of inflation expectations from the target. That being said, measuring the anchoring of inflation expectations is not an easy task. There are many sources of data, which do not necessarily overlap. Indicators are drawn from the financial markets and from surveys of professional forecasters, financial analysts, consumers and firms.

Inflation expectations remain under control

This article reviews several measures of inflation expectations and delivers a rather reassuring message: despite the increase in short-term inflation expectations (one year ahead, for example), medium- and long-term inflation expectations (five or ten years ahead) have thus far remained close to the ECB’s 2 % target.

There are, however, a number of signals that should not be ignored. For instance, at the end of August 2023, financial market data indicated inflation expectations of 2.6 % over the medium term. Moreover, inflation expectations from surveys of professional forecasters indicate that a relatively high proportion of respondents expect inflation to be above 2.5 % in the medium term. Finally, although more difficult to interpret - not least because of perception bias – consumer inflation expectations have also risen.

In brief, the anchoring of inflation expectations requires ongoing attention. The longer inflation strays from the ECB’s target, the greater the risk of inflation expectations going off target as well. Such a loss of credibility would oblige the central bank to dispense tough medicine and drastically tighten credit conditions, at the risk of dragging the economy into a recession.