Since the financial crisis, inflation has been persistently low in the euro area. This development has led some central bank observers and financial market participants to question the ability of central banks to deliver on their mandate – that is, in case of the European Central Bank (ECB), to maintain price stability which is defined as a rise of inflation rates below, but close to 2 percent over the medium term. At a SAFE Policy Lecture on 11 July, Benoît Cœuré, Member of the Executive Board of the ECB, talked about the role of inflation expectations in the conduct of monetary policy.
Cœuré said that since the crisis, market-based long-term inflation expectations had fallen and that this fall had accelerated since the start of the year. However, according to him, the fall of market-based inflation expectations does not necessarily reflect concerns about the credibility of the ECB’s monetary policy. He argued that the drop in long-term market-based inflation expectations is a global phenomenon and that survey-based inflation expectations have stayed consistently above market-based expectations and are closer to the ECB’s definition of price stability.
Ultimately, Cœuré argued that market-based inflation expectations are much more in line with survey-based expectations if corrected for the inflation risk premium – that is, the compensation investors demand for bearing risks related to the uncertainty around the future inflation path. However, this risk premium cannot explain the fall in short and medium-term expectations. “Recent market developments, therefore, suggest expectations that the current weakness in the euro area and global demand will persist”, Cœuré said.
Households are likely to notice price changes
He then talked about the expectations of households. Cœuré pointed to the fact that several studies have found that many people´s inflation perceptions are substantially different from actual inflation outcomes. According to him, many households are not aware of central banks´ inflation aims. “Central banks need to do much more to bring the monetary policy discussion to the broader public, and thereby improve their accountability”, Cœuré said.
At the same time, households may have a fairly good understanding of changes in the trend of current inflation and these changes are likely to inform their expectations about future inflation, he said. Cœuré argued that most individuals use simple rules of thumb to form their short-term inflation expectations, while current inflation rates, and in particular price changes of frequently purchased goods, such as energy and food, seem to be the most widely used heuristic in this respect. Surprisingly, changes of household inflation expectations are often very similar to those of professional forecasters and financial market participants, he said. For Cœuré, this explains that some degree of inflation persistence is a natural and inevitable phenomenon.
More recently, however, he showed that a growing gap has emerged between the inflation expectations of market participants on the one side, and household and professional forecasters on the other. Today, households are much less skeptical about the future, he said. These household expectations might be better than professional inflation forecasts, Cœuré said. He pointed to strands in the literature which suggest that household inflation expectations are often better predictors of future inflation outcomes. “Financial market participants are not particularly good at predicting future inflation”, he said. According to him, market-based inflation expectations are less reliable and useful for firms and consumers because of their frequent revision. In addition, household inflation expectations affect households´ consumption decisions and therefore growth and price developments. “When consumers expect inflation to rise, they tend to spend more”, Cœuré explained. Further, he argued that household expectations are a better proxy of firms´ pricing decisions than those of professional forecasters or financial market participants.
Cœuré emphasized that policymakers should never ignore signals from the financial markets but should also not focus on them too narrowly either. However, he said that the protracted period of low inflation had caused concerns among financial market participants that current subdued underlying price pressures would persist in the medium term. “The Governing Council is taking these concerns seriously”, he said.
Speech by Benoît Cœuré, Member of the Executive Board of the ECB, at the SAFE Policy Lecture, Frankfurt am Main, 11 July 2019
Video of the SAFE Policy Lecture with Benoît Cœuré , 11 July 2019: Inflation expectations and the conduct of monetary policy