In contrast to developments in short-term inflation expectations, long-term euro area inflation expectations and the associated risks have remained relatively stable (slide 15). For example, the five-year forward break-even inflation rate (BEIR) five years ahead has fluctuated between 2.0% and 2.5%. Moreover, a decomposition of BEIRs into inflation expectations and related premia suggests nonetheless that the term structure of inflation risk premia in the euro area is upward sloping and its fluctuations are the main driver of fluctuations in BEIRs, with (long-term) inflation expectations anchored at levels consistent with price stability. 9 Recent research has also shown that there are substantial differences in the determinants of short and long-term inflation expectations derived from BEIRs in the euro area. 10 In  7  See Ejsing, J., J.A. Garcia and T. Werner (2007) “The term structure of euro area break-even inflation rates: the impact of seasonality”, ECB Working Paper No 830; Gurkaynak, R., B. Sack and J. Wright (2009), “The TIPS yield curve and Inflation Compensation”, American Economics Journal: Macroeconomics, forthcoming.”  8  Other inflation derivatives allow investors to hedge against inflation rates exceeding certain threshold (inflation cap) or being below a certain level (inflation floor) and thereby convey information about the value of the perceived risk of hitting those thresholds by estimating option-implied densities and measures of perceived market uncertainty. Since the lowest maturity of caps and floors are two years (in some cases three years), the volatility is an average of the one and two-year (and three-year) caplet volatility.

It plots the latest HICP inflation forecasts from the Euro Zone Barometer – a publication that produces macroeconomic and financial forecasts every month from a number of major economic forecasters in Europe. In this month’s edition, forecasters expect the spell of negative inflation in 2009 to last on average for a few months. Looking at the range of individual responses (which is shown as a shaded area), there is some disagreement between the highest and lowest forecast. But even in the lowest forecast, the period with negative inflation rate is expected to last no more than two quarters. Furthermore, according to the same survey, inflation projections for 2010 have been gradually revised downwards since January 2009 as economic conditions have deteriorated. This phenomenon is illustrated in slide 8, as a month-to-month shift to the left of the inflation forecasts. Nevertheless, the median projection still remains above 1%. So, if there is no evidence of a generalised and persistent fall in the price level in the latest inflation outturns, what is underpinning current deflationary fears? As I see it, when people think about deflation, they have in mind two possible scenarios. The first is that the accumulation of economic slack due to the recession may exacerbate downside risks to price developments, which in turn may lead to outright deflation as monetary policy loses traction in stabilising output. The second scenario is that a spell of negative headline inflation rates – perhaps due to the temporary impact of energy and food prices – might dislodge inflation expectations.