Measuring inflation expectations and the effect of monetary policy: Euro area inflation compensation and ECB policy announcements

This thesis looks at ways of measuring the inflation expectations of economic agents, by constructing a market-based measure from the inflation compensation of government bonds. Inflation compensation is defined as the difference in yields between nominal and index-linked government bonds leaving investors indifferent between holding the two. Inflation compensation is a true measure of expectations only if investors are risk neutral, hence the presence of liquidity and inflation risk premia is evaluated and these premia are extracted. After deriving inflation expectations in this way, the effect of monetary policy measures and announcements on expectations is analysed. The focus is on the Euro area experience for the time period 2007 – 2015. The data used in the analysis consists of daily prices of French government bonds, both nominal and linked to the Euro area harmonized consumer index (HICP). The monetary policy measures evaluated are those conducted by the European Central Bank (ECB) during the sample period, including changes to key interest rates and non-standard monetary policy measures. The results show that there are clear and time-varying liquidity and inflation risk premia in the inflation compensation. The effect of liquidity is not substantial and is stable throughout the sample reflecting good liquidity in index-linked French government bonds. The extraction of the inflation risk premium is challenging due to the lack of observations and unrealistically low variance of the survey expectations used to identify the true inflation expectations. Hence, the final expectations and inflation risk premium are obtained only at a quarterly frequency. The inflation compensation measure exhibits strong volatility during the sample period, at all of 5-, 10and 15-year horizons. This would suggest that Euro area inflation expectations are weakly anchored. Expectations fell dramatically during the height of the financial crisis in 2008, but rebounded quickly afterwards. The trends for the different time horizons began dispersing thereon, reflecting growing uncertainty and deflationary fears in the short term. The daily series of both liquidity-adjusted and non-adjusted compensation is used in an event study context to determine whether inflation expectations react to the ECB’s monetary policy measures and announcements. There appears to be a positive correlation between past values of expectations and the present ECB rate, and a negative correlation between the current rate and future expectations, pointing to monetary easing being able to increase expectations when they are low. Rate change announcements look to be well anticipated, with little change in expectations on days of the announcements. Non-standard measures are less anticipated and they succeed in raising expectations, albeit briefly. Finally, the effects of the ECB’s expanded asset purchase programme (EAPP) are evaluated. It appears the launch of the programme raised expectations significantly for a while, before they fell back to previous levels during the summer of 2015. The expectations were rising again at the beginning of autumn 2015.