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Are inflation expectations getting out of hand?
Macro

Are inflation expectations getting out of hand?

Supposedly, people are sufficiently rational and well-informed to always, immediately, and accurately see through the veil of inflation.
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22 SEPT, 2023

By DWS

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One of the more widely recognized problems with contemporary macroeconomics is that it leaves very little room for money illusions. Supposedly, people are sufficiently rational and well-informed to always, immediately, and accurately see through the veil of inflation. Some prices and wages might initially be a little rigid. However, nominal amounts will readily and accurately adjust in line with rational inflation expectations, the logic goes, whenever wage and price setters get their chance to reset. Meanwhile, markets will accurately price in just such behavior. In turn, that means you can use prices for financial assets, such as bond contracts subject to inflation indexation, to gauge market inflation expectations.  

Our Chart of the Week provides the results of such an exercise. It shows the spread between break-even inflation rates over the next 10 years – derived by comparing the yields of nominal and inflation-linked bonds of 10-year maturity – for German Bunds and U.S. Treasuries. Glancing at these suggests that for the past decade, markets assumed that U.S. inflation would run above German inflation, which one might think of as a proxy for European inflation. Now that inflation has hit Europe particularly hard, markets seem to assume that the old continent will see higher inflation rates for a decade. Does that mean that the European Central Bank (ECB) will have its work cut out in defending its credibility, perhaps even more so than the U.S. Federal Reserve (Fed)?

Inflation expectations for Germany now exceed those anticipated by bond markets for the U.S.

Sources: Bloomberg Finance L.P., DWS Investment GmbH as of 9/20/23.

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We would not quite go that far. “The ECB has plenty of good reasons to lean against inflation. Following the latest interest rate hike, we think it will keep rates at current elevated levels, probably for quite a while. For how long will depend on incoming data. But market-derived inflation expectations are only one of many measures they will be watching closely in coming months, and probably not particularly high up”.

Ulrike Kastens, Senior Economist Europe at DWS.

For one thing, market inflation expectations have been quite volatile themselves. For another, rational inflation expectations are useful theoretical constructs to come up with tractable models of how economies work. But postulating them is no substitute for actually looking at how wages and prices are set, or how expectations are formed in any particular country in the real world. How indexed bond contracts are structured and indexed, not to mention market liquidity, differ not just between the U.S. and Germany, but even within the Eurozone too.

Different countries in the common currency area are also experiencing quite distinct dynamics, making transatlantic comparisons of small differences between the U.S. and one, admittedly important, country fairly meaningless for monetary policy. Finally, inflation itself is surprisingly hard to properly measure.

We are hopeful that the skilled economists at the ECB will know as much, realizing that markets are not always quite as rational and well-informed as some economic commentators appear to think.

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