Abstract
This chapter explores the information content of long-term inflation expectations inferred from break-even inflation rates and the policy implications thereof. Evidence established that actual and counterfactual long-term inflation expectations are “poorly” anchored. Evidence reveals there is pass-through from positive long-term inflation expectation shock to headline CPI inflation. Long-term inflation expectations propagate the adverse inflation shocks into the real economy. Periods of heightened inflationary pressures result in elevated long-term inflation expectations. In policy terms, this suggests policy makers should adopt a policy stance that aims to break down such adverse reinforcing tendencies.
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Notes
- 1.
Bernanke (2003) defines well-anchored long-term inflation as those in which a one-off adverse shock to, for example, energy and food prices, does not lead to a permanent increase in inflation but only a change in relative prices. Similarly, if inflation expectations are well-anchored, changes in energy and food prices should have relatively little influence on core inflation.
- 2.
In contrast to the traditional rational-expectations model of inflation and inflation expectations which implies that economic agents know the long-run equilibrium inflation rate. As such, their long-run inflation expectations do not vary over time in response to new information (Bernanke 2003).
- 3.
The persistence of shocks matters.
- 4.
The Banks’ quantitative definition of price stability refers to all-items headline inflation. However, the MPC does refer analyses the information contained in various measures of core inflation as operational guides for the policy stance.
- 5.
Break-even inflation rates are computed as the difference between the nominal bond yield and the real yield (yield of the inflation-linked bond) can be decomposed into inflation expectations and related premia from financial market participants.
- 6.
Hördahl (2008) finds larger risk premia for the euro area. As a result, the euro area adjusted break-even rate is also lower relative to the unadjusted rate. Furthermore the adjusted break-even rate is much closer to the survey forecasts than the unadjusted rate.
- 7.
We also note that the BER five-year-ahead financial analysts’ inflation expectations are only available for the period starting 2011Q3. We are also cognisant of the weaknesses and criticism of survey-based inflation expectations. However, survey measures of inflation expectations are the main alternative source of information on inflation expectations for policymakers. Furthermore, they are not subject to inflation uncertainty, liquidity risk, and other risk factors embedded in break-even inflation rates (Christensen et al. 2004).
- 8.
Counterfactual refers to long-term inflation expectation which exclude the contributions of expectations to long-term expectations.
- 9.
This kind of communication is not very different to the previous “escape clause”.
- 10.
Also known as the expectations trap hypothesis.
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Ndou, E., Gumata, N. (2017). Upside Risk Factors to the Inflation Outlook and Long-Term Inflation Expectations. In: Inflation Dynamics in South Africa. Palgrave Macmillan, Cham. https://doi.org/10.1007/978-3-319-46702-3_29
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DOI: https://doi.org/10.1007/978-3-319-46702-3_29
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