Bank of England
Measuring market-based core inflation expectations
Abstract
- Abstract
We build a novel term structure model for pricing synthetic euro area core inflation-linked
swaps, a hypothetical swap contract indexed to core inflation. - The model provides estimates of market-based expectations for core inflation, as
well as core inflation risk premia, at daily frequency, whereas core inflation expectations from
surveys or macroeconomic projections are typically only available monthly or quarterly. - We
find that core inflation-linked swap rates are generally less volatile than headline inflationlinked swap rates and that market participants expected core inflation to be substantially
more persistent than headline inflation following the 2022 energy price spike. - In this paper, we aim to infer market-based core inflation expectations, which are otherwise
not directly observable because no financial asset directly tied to core inflation exists. - We deem this second assumption reasonable because HICP inflation itself is a linear combination
of core as well as energy and food inflation. - The level of 2 percent and relatively low volatility of
long-term inflation expectations suggests that inflation expectations are firmly anchored at the
ECB?s 2 percent inflation target. - This assumption appears reasonably uncontroversial,
as core inflation is a sub-component of headline inflation, which the observable headline ILS
rates are tied to. - Our estimates of core ILS rates reflect both market participants? genuine core
inflation expectations and a core inflation risk premium, but our model explicitly allows for
this decomposition. - The model-implied estimates of core ILS rates appear reasonable along several dimensions:
(i) like realized core inflation is less volatile than headline inflation, the core ILS rates are less
volatile than headline ILS rates, (ii) core ILS rates comove less with oil prices than headline
ILS rates, (iii) the core inflation expectations, as reflected in core ILS rates, typically evolve
similarly as the core inflation projections by Eurosystem staff, and (iv) consistent with market
commentary at the time, core ILS rates suggest that market participants expected core inflation
to be substantially more persistent than headline inflation following the 2022 energy price spike. - To the best of our knowledge, we are the first to price core ILS rates and decompose them into
market-based expectations for and risks around the core inflation outlook. - Our approach to inferring core ILS
rates from headline ILS rates, realized headline and core inflation as well as survey expectations
for headline and core inflation is also related to Ang et al. - Relative
to their study, we separately measure core inflation expectations and risk premia, we provide
core inflation expectations at a higher-frequency, and we provide evidence on the causal effectsECB Working Paper Series No 2908
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of monetary policy shocks on core inflation expectations and risk premia.
- Specifically, we decompose the synthetic core ILS rates
into average expected core inflation over the lifetime of the swap contract and a core inflation
risk premium that compensates investors for core inflation risk. - In
our model below, this term is constant over time and relatively small, so we will simply refer
to the core inflation risk premium as the difference between the core ILS rate and the average
expected core inflation over the lifetime of the swap contract. - 3.2
Core ILS rates
To have a joint model for headline and core ILS rates, we need one further assumption on the
dynamics of realized core inflation. - The assumption that core inflation is driven by the same set of factors as headline inflation
should be relatively uncontroversial: since headline inflation is a weighted average of core and
food and energy inflation, it should reflect any factors driving core inflation. - If there are factors
driving food and energy inflation, which do not show up in core inflation, then those factors
should still show up in headline inflation. - In step two, to be able to infer the factor
loadings of core inflation, we would regress realized core inflation onto the estimated latent
factors to identify the additional parameters in equation (12). - Before the fourth
quarter of 2016, the SPF did not ask respondents for their core inflation expectations, so we
are not able to use survey-based information about core inflation before then. - Before
2016, the fitted core inflation series is somewhat above the realized one, potentially reflecting
that the model has limited information about core inflation over this early period due to the
lack of information about core inflation from surveys. - This could have been the
case if one of the factors moved core inflation and energy and food inflation in exactly offsetting
direction, so the overall impact on headline inflation was exactly zero. - During 2021, for example, there were
ECB Working Paper Series No 2908
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Figure 7: Decomposition of synthetic core ILS rates
2y core ILS5y core ILS
5
45
ILSpremia
exp
4
ILS
premia
exp
3
3
2
2
1
1
0
0
-1
-1
-2
2017 2018 2019 2020 2021 2022 2023-2
2017 2018 2019 2020 2021 2022 202310y core ILS
5y5y core ILS
5
45
ILSpremia
exp
4
ILS
premia
exp
3
3
2
2
1
1
0
0
-1
-1
-2
2017 2018 2019 2020 2021 2022 2023-2
2017 2018 2019 2020 2021 2022 2023Note: Synthetic core ILS rates decomposed into genuine core inflation expectations and core inflation risk
premia. - ECB Working Paper Series No 2908
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Figure 8: Decomposition of ILS rates
2y ILS5y ILS
5
45
ILSpremia
exp
4
3
3
2
2
1
1
0
0
-1
-1
-2
20062010
2014
2018
2022
-2
2006ILS
2010
10y ILS
2018
2022
5
ILSpremia
exp
4
3
3
2
2
1
1
0
0
-1
-1
-2
20062014
exp
5y5y ILS
5
4premia
2010
2014
2018
2022
-2
2006ILS
2010
premia
2014
2018
exp
2022
Note: ILS rates decomposed into genuine core inflation expectations and core inflation risk premia.
- We find that the headline inflation risk premium
indeed does responds more strongly than the core inflation risk premium. - The key
assumption underlying our approach is that traded headline ILS rates span core inflation, whichECB Working Paper Series No 2908
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should be reasonably uncontroversial as core inflation is a sub-component of headline inflation.
- We fit the model to euro area headline ILS rates, realized headline and core inflation, and
both headline and core inflation expectations reported in the SPF. - Decomposing our core ILS rates into genuine core inflation expectations and core
inflation risk premia shows that shorter maturities mainly reflect core inflation expectations,
while the core inflation risk premium matters relatively more for longer maturities. - Our results suggest that a monetary policy tightening surprise significantly lowers
near-term core inflation expectations, although less so than it lowers headline inflation expectations.
Managing the transition to central bank digital currency
Piero Cipollone: Modernising finance: the role of central bank money
The paper demonstrates how agreement-level data can be used to study drivers of aggregate negotiated wage growth, as well as monitor the breadth of wage increases and account for time-varying factors such as one-off payments, when assessing wage pressures.
- The paper demonstrates how agreement-level data can be used to study drivers of aggregate negotiated wage growth, as well as monitor the breadth of wage increases and account for time-varying factors such as one-off payments, when assessing wage pressures.
- Lastly, the paper shows that the new indicators can provide reliable signals about current and future developments of wage pressures in the euro area while also serving as important cross-checking tools for negotiated wage growth forecasts.
The macroeconomic effects of global supply chain reorientation
We analyse the macroeconomic
- We analyse the macroeconomic
effects of supply chain reorientation through localisation policies, using a global dynamic
general equilibrium model. - While arguments about comparative advantage, the potential forgone benefits of international specialisation and industry- and product-specific disruptions are familiar, there is less
analysis on the macroeconomic effects of supply chain changes resulting from localisation policies. - The large sensitivity of the global economy to the recent supply chain shocks suggests that
the international trade reconfiguration implied by localisation policies could also have sizable
impacts on key macroeconomic variables such as output, employment and inflation. - Thus, localisation focuses on the
goods in our model most closely related to global supply chains. - Retaliation also attenuates any positive effects from
reshoring on output and implies a reduction in the volume of overall international trade. - This finding calls for limiting the scope of reshoring, such as by focusing on vital goods that are
most susceptible to supply chain disruptions. - Either that, or the economic costs are considered a worthwhile trade-off for an increase
in security of supply, for example. - While arguments about comparative advantage, the potential forgone benefits of international specialisation and industry- and product-specific disruptions are familiar, there is less
analysis on the macroeconomic effects of supply chain changes resulting from localisation policies. - Recent supply chain shocks have had large effects, with disruptions in 2021 estimated
to have reduced euro area GDP by around two percent and doubled the rate of manufacturing producer inflation (Celasun et al., 2022). - To analyse this issue, we simulate a (partial) reshoring of production back to Europe in
a global dynamic general equilibrium framework. - Thus,
localisation focuses on the goods in our model most closely related to global supply chains.3 We
model reshoring through a direct change to the export goods? production-function parameters. - Since reshoring
effectively shortens the supply chain, the sum of markups along the chain falls. - This means that imports that are at the end of the supply chain (i.e.
- In particular, our work relates to papers examining the potential for countries to reduce
their exposure to global supply chains. - (2021) demonstrate that reduced reliance on foreign inputs does not mitigate pandemicinduced contractions in labour supply.
- (2021) find no evidence of a relationship
between global value chain integration and macroeconomic volatility. - This dynamic, along with factors such as natural disasters, climate-change
induced volatility and terrorism mean that supply chain disruptions could be a new normal
(Grossman et al., 2021). - Our work contributes to the literature providing dynamic general equilibrium analyses of
protectionist policies, in particular those using global macroeconomic models to quantify trade
policy changes. - (2008) analyse the effect of a rise in protectionism in response
to rising global trade imbalances. - Linde? and Pescatori (2019) find that although the macroeconomic costs of a
trade war are substantial, a fully symmetric retaliation is the best response. - (2020) consider a rich input-output structure and demonstrate that closer integration amplifies
the adverse effects of protectionist trade policies. - Several recent studies have also examined the economic effects of a global trade fragmentation.
- First, we modify a dynamic general
equilibrium model of the global economy in order to analyse the transmission of localisation
policies. - This allows for a comprehensive treatment of cross-border macroeconomic interdependences and spillovers between the different regions.
- 4
There is, however, substantial cross-country heterogeneity in terms of impact, with small open economies
(SOEs) reliant on global supply chains more affected. - ECB Working Paper Series No 2903
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Second, we are able to assess both long-run effects and the transition dynamics of localisation
policies. - Our model contains a detailed monetary block and captures inflation dynamics, which is a key
concern for supply chain reorientation. - Overall, our paper contains a careful analysis of the key aspects of the localisation debate,
including effects of localisation on domestic competition and efficiency. - Section 2 provides a brief overview of the model, the modifications to examine
global supply chain reorientation, some key details on the calibration and a brief discussion of
the nature of our exercise. - (2020) for discussions of the relative strengths and weaknesses of
trade and macroeconomic models in assessing large economic shocks. - 2.1
Supply chain reorientation
Our analysis focuses on imported inputs used to produce goods for export, as the introduction
of localisation policies is in response to recent disruptions to global supply chains. - Since reshoring
effectively shortens the supply chain, the sum of markups along the chain falls. - Further to
these effects, engagement with global firms provides an opportunity for knowledge spillovers to
local firms (Criscuolo et al., 2017). - This finding calls for limiting the scope of reshoring, such as by focusing on vital goods that are
most susceptible to supply chain disruptions. - (B12)
Adjusting the share of local inputs in export goods, of course, affects prices and quantities all
along the supply chain.
Estimates of the natural interest rate for the euro area: an update
The natural rate of interest is defined as the real rate of interest that is neither expansionary nor contractionary.
- The natural rate of interest is defined as the real rate of interest that is neither expansionary nor contractionary.
- A wide range of estimates obtained from a suite of models and approaches suggests that cyclical measures of euro area r* have been edging higher recently.
Quarterly Review
The Company announces that its quarterly review as at 31 December 2023 is now available, a summary of which is provided below.
- The Company announces that its quarterly review as at 31 December 2023 is now available, a summary of which is provided below.
- The full quarterly review is available on the Company’s website at:
It was a positive fourth quarter for most financial assets as investor sentiment was bolstered by the easing of inflationary pressures, optimism about forthcoming rate cuts by central banks and a potential economic ‘soft landing’. - After an initial period of weakness, the year ended with a powerful two-month rally in bond and equity markets.
- During times such as these, when credit spreads compress, we tend to favour going up in quality rather than chasing yield.
MUFG Economic Research Office releases 2024 outlook report; considers five key questions for the year ahead
NEW YORK, Jan. 18, 2024 /PRNewswire/ -- Mitsubishi UFJ Financial Group (NYSE: MUFG) Economic Research Office issued its 2024 outlook report titled " Five Key Questions for 2024 ," in which contributors Henry Cook, Senior Economist, London; Agron Nicaj, U.S.
- NEW YORK, Jan. 18, 2024 /PRNewswire/ -- Mitsubishi UFJ Financial Group (NYSE: MUFG) Economic Research Office issued its 2024 outlook report titled " Five Key Questions for 2024 ," in which contributors Henry Cook, Senior Economist, London; Agron Nicaj, U.S.
- 2023 can be summarized as a year of resilience as advanced economies avoided sharp downturns despite rapid monetary policy tightening.
- This tees up some key questions for the year ahead from a macro perspective, the most important of which relates to the durability of the U.S. expansion.
- To access the complete outlook report, please visit the MUFG Americas website here .
US Treasury market conditions and global market reactions to US monetary policy
At the same time, leveraged funds have built up unusually large net short positions in the US Treasury futures market.
- At the same time, leveraged funds have built up unusually large net short positions in the US Treasury futures market.
- This box provides empirical evidence that the impact of a US monetary policy shock on domestic and global bond markets may vary depending on conditions in the US Treasury market.
Bitcoin: four reasons why the price should surge in 2024
Notably there was the conviction of FTX CEO Sam Bankman-Fried for fraud.
- Notably there was the conviction of FTX CEO Sam Bankman-Fried for fraud.
- Viewed as a test case for the majority of cryptocurrencies, the US Securities Exchange Commission (SEC) is currently appealing.
- While all this was happening, the bitcoin price rose away from the lows of late 2022.
1. ETFs
- ETFs already exist for everything from oil to the FTSE 100 to even regions and countries.
- Until now, the only ETFs permitted for crypto in the US have been for the futures markets.
- There are various reasons why many commentators think the SEC may now end its opposition to such an ETF.
- Further, Hong Kong’s regulatory authority has announced it is open to spot bitcoin ETF applications and has laid down guidelines permitting several varieties.
- As well as the basic model that we may soon see in the US, where investors would buy into bitcoin ETFs with dollars, Hong Kong is open to a second variety known as “in-kind”.
2. Interest rates
- Jerome Powell, chair of US central bank the Federal Reserve, has indicated that interest rates may have peaked, and that the Fed is likely to cut them during 2024.
- If interest rates are cut or even stabilise in 2024, it could make bitcoin (and other digital assets) more attractive to investors, since its limited supply makes it a hedge against traditional currencies losing value over time.
In addition, the US and other economies may enter a recession in the later half of 2024 due to the lagged effects of the interest rate hikes. Equally, we saw a number of bank failures in 2023, predominantly in the US. In the event of a recession or more bank problems, governments may be forced to provide stimulus packages and print more money. This would further devalue currencies and make bitcoin still more attractive.
3. The halving
- Bitcoin runs on an online ledger known as a blockchain, in which entries are validated by “miners” using arrays of computers to solve complex mathematical puzzles.
- The reward began at 50 bitcoin in 2009 and is expected to fall from 6.25 bitcoin to 3.125 bitcoin around the middle of April 2024.
- Halving effects
4. Blockchain developments
- Until now, NFTs and new cryptocurrencies have mostly been issued on other blockchains such as ethereum.
- We are also seeing growing adoption of the Lightning network, a layer above the bitcoin blockchain that enables much faster transactions.
- All these changes are resulting in increased demand for bitcoin, which in turn may lead to higher prices.
Andrew Urquhart owns some cryptocurrencies. Hossein Jahanshahloo does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.