Download What drives Inflation Expectations?

What drives Inflation Expectations?∗
Luca Gambetti†
Universitat Autónoma de Barcelona and Barcelona GSE
Laura Moretti‡
Central Bank of Ireland
February 2016
PRELIMINARY AND INCOMPLETE
Abstract
Long-term inflation expectations have declined and remained subdue in many advanced economies. We analyze the recent developments in long-term market based
inflation expectations in a group of six OECD countries: Australia, Euro Area, Japan,
Sweden, UK, and US over the sample 2007-2015. We evaluate the impact of the “secular
stagnation” hypothesis, a persistently lower output growth, and of oil prices fluctuations. We find that the recent decline in long-term market based inflation expectations
cannot be explained entirely by a “secular stagnation” shock, but it is also driven by
an oil price shock that it is perceived as permanent.
JEL classification: E31, C22.
Keywords: Inflation expectations, Oil prices, VAR.
∗
The views expressed in this paper are solely those of the authors and do not reflect the views of the
Central Bank of Ireland or the European System of Central Banks. All errors are ours.
†
Universitat Autónoma de Barcelona and Barcelona GSE. E-mail: [email protected]
‡
Central Bank of Ireland. E-mail: [email protected].
1
“Convincing evidence that longer-term inflation expectations have moved lower would be
a concern because declines in consumer and business expectations about inflation could put
downward pressure on actual inflation, making the attainment of our 2 percent inflation goal
more difficult.”
Janet Yellen, Fed Chair, December 2, 2015.
“The decline in oil prices had also triggered a downward adjustment in market-based
measures of inflation expectations in the euro area and had contributed to a decline in bond
yields and significantly higher market volatility.”
Accounts of the ECB Governing Council Meeting, 2-3 December 2015.
1
Introduction
Long-term inflation expectations have declined and remained subdue in many advanced
economies. In particular, the recent decline in market-based inflation expectations not only
in the euro area, but also in the US is particularly puzzling given their different stages in
the economic recovery.
Many studies have linked this recent decline to the impact of the drop in oil prices.
Instead, we analyze the decline of long-term inflation expectation in the context of “secular
stagnation”, as discussed by Summers (2013, 2015b, and 2015d). We ask whether the decline
in long-term inflation expectations is a sign of “secular stagnation”, or whether other factors,
such as the recent drop in oil prices, are driving it.
The term “secular stagnation” has been resurrected by Summers (2013, 2014, 2015a,
2015b, and 2015c) and refers to the persistent decline in output growth. He argues that
this protracted shortfall in output is driven by a drop in investment in capital goods that
ultimately leads to a failure in reaching full employment. Moreover, he supports the view
that this is due to a chronic excess of savings over desired investment. While his analysis
focuses mainly on the decline in the real equilibrium rate, persistently low long-term inflation expectations can also be a sign that markets expect slow recovery with an absence of
2
inflationary pressures (See Summers, 2015d).
Monitoring long-term inflation expectations is crucial for a central bank. Since there is
a lag in the transmission of monetary policy, central banks need to monitor also inflation
expectations, among other factors that are likely to have a persistent impact on inflation,
when deciding the monetary policy stance. Moreover, inflation expectations are an indicator
for evaluating the credibility of a central bank, or its commitment to maintain a low and
stable inflation rate over time. In general, long-term inflation expectations are defined as well
anchored if they display little sensitivity to incoming news and conjunctural macroeconomic
data. In fact, there is no reason why developments driven by short-term and conjunctural
shocks, which fade away within conjunctural time horizons, should significantly affect inflation expectations that have instead a long-term nature. In contrast, when the private sector
is uncertain about the ability (or willingness) of the central bank to maintain a certain
inflation objective, long-run inflation expectations tend to react to incoming news.1
For these reasons, the recent increase in correlation between long-term inflation expectations and oil prices might be worrisome because it might signal that inflation expectations are
less anchored. Badel and McGillicuddy (2015) show that the correlation between five-year
breakeven inflation expectations and (log) oil price changes has increased since 2003.2 Moreover, they disentangle the oil price changes due to supply, demand and oil-specific demand
following Kilian (2009). They show that in 2014-2015 every component is highly correlated
(above 0.6) with breakeven inflation expectations. Elliot et al. (2015) show that changes in
oil prices have statistically significant impact on 5years-in-5years inflation swap rates for the
euro area and the US, but not for UK. Sussman and Zohar (2015) also show a tightening in
the relationship between global demand and medium term inflation expectations.
To our knowledge, the only paper that tries to offer an explanation for the relative low
market-based inflation expectations for the US and the euro area is Ciccarelli and Garcia
(2015). They suggest that there have been relevant spillover effects from the euro area long1
See Beechey et al. (2011).
They show that the correlation between the US five-year breakeven forward rate and oil prices has
increased from 0.5 in 2003-2007 to 0.9 in 2014-2015.
2
3
term inflation expectations to the US since the summer 2014. They use a factor model VAR
with three countries: euro area, US, and UK. They identify common international shocks as
those shocks affecting inflation expectations contemporaneously in the three countries, and
country-specific shocks that can lead to spillovers that are assumed to happen at least with
a month-lag.3
However, the definition of what constitutes a common shock depends on the frequency
of the data. Since they use monthly data, a shock that starts in a country and it spills over
into other financial markets within one-month is classified as global shock. On the other
hand, an international shock that affects one country first and the others only after a month
or more would be classified as idiosyncratic shock transmitted by spillovers. However, if a
common shock has effects that are longer-lived in one country (for example the euro area)
with respect to another, this identification scheme might attribute this to spillovers.
In this paper, we investigate the role of “secular stagnation” in explaining the decline in
long-term inflation expectations and of the recent movements in oil prices for a sample of
six OECD countries: Australia, Euro Area, Japan, Sweden, UK, and US over the sample
2007-2015. We use a three-variable VAR model including industrial production, oil prices
and 5-years-in-5 years forward inflation swap rates4 , in this order, for every country in our
sample. We use long-run identification restrictions á la Blanchard and Quah and we identify
a long-run permanent shock to the level of industrial production, which we call the “secular
stagnation” shock.
A shock with permanent effects on the level of oil prices can be justified by the structural
changes that have occurred in the oil market. Dale (2015) analyzed some of the changes
in the market. First, the global demand for energy will increase depending on the strength
of global recovery. Second, concerns for global warning and carbon footprint will change
the form of energy demanded and will privilege natural gas and renewable sources. Third,
3
The model permits the decomposition of the variance of the h-step ahead forecast error for inflation
expectations in three sources: unexpected common shocks, unexpected domestic shocks, and spillover effects
of unforeseen domestic shocks to other countries.
4
A 5-years-in-5 years forward inflation swap rates denote the market expectation of the average level of
inflation over 5 years 5 years from now, more details in Section 2.
4
technology improvements will improve energy efficiency. Finally, the supply of oil will remain
high due to shale oil produces, among other factors.5
Fist, we estimate a VAR for each country in the sample. We show that the historical decomposition when using only the “secular stagnation” shock is able to explain the downward
trend in inflation expectations for the euro area, the US, Sweden, but not the deep recent
decline. In fact, only when combining the contribution of both the “secular stagnation”
shock and the permanent shock to oil prices, we are able to explain the dynamics of the
series.
Then, we present some preliminary results on how much a common factor component
drives the movements in inflation expectations for the countries in our sample. Moreover, we
estimate a VAR including the estimated common factor for long-term inflation expectations.
We plan to extend the work...
The rest of the paper is organized as follows. Section 2 describes the measures of inflation
expectations and the methodology used in the paper. Section 3 presents the empirical results.
Section 4 concludes.
2
Data and Methodology
In this section, we briefly describe the data and the empirical methodology used in the paper.
2.1
Measures of market-based inflation compensation
Given the delays in the transmission of monetary policy, it is crucial for central banks to
monitor also private sector’s inflation expectations when deciding the monetary policy stance.
Moreover, inflation expectations are also monitored to evaluate the credibility of a central
bank, or how the public perceive its commitment to maintain a certain target of inflation.6
In fact, as defined in Beechey et al. (2011), inflation expectations are “firmly anchored” if
5
See also Dale (2016).
Gürkaynak et al. (2010) and Erhmann et al. (2011) present analysis of anchoring in long-term inflation
expectations.
6
5
investors and other private actors in the economy “have a high degree of ongoing consensus
regarding the central banks long-run inflation objective.” In contrast, when the private sector
is uncertain about the central banks inflation objective, long-run inflation expectations tend
to react to incoming news.
Central banks can relay both on survey measures and market-based measures. Survey
measures present the drawback of being available only at low frequency (for example, the
Survey of Professional Forecasters7 is available at quarterly frequency). However, while
financial market indicators have gained more prominence because they are available at high
frequency, they are measures of inflation expectations plus other premia.
The usual measures of inflation expectations are the breakeven inflation rate and the
inflation swap rate. Break-even inflation rate is the spread between the yields of an ordinary
nominal government bond and the yields of the inflation linked bond, a bond with a coupon
and principal indexed to consumer price index, at the same maturity.
Inflation swap rates is, instead, a derivative instrument in which a fixed rate is exchanged
for a floating rate linked to an inflation index8 . Usually zero-coupon inflation swaps are the
most liquid instruments traded in this market.
It is important to point out that break-even and inflation swap rates are measures of
“inflation compensation” rather than of “inflation expectations” because they do not reflect
only expected inflation, but also various risk premia (see Yellen, 2014). In particular, there
is an inflation risk premium, the compensation that holders of nominal securities demand
for bearing inflation risk, and a liquidity premium, driven by the liquidity difference and
shifts in the relative supply and demand of nominal versus inflation indexed securities (for
break-even inflation rates), and driven by the transactions costs incurred by inflation brokerdealers when hedging the exposure to an inflation swap position with the purchase of a bond
(for the inflation swaps).
7
The quarterly ECB Survey of Professional Forecasters collects forecasts for the euro area HICP inflation
at 1, 2 and 5 years ahead. Respondents are also required to provide a quantitative assessment of uncertainty
surrounding the reported point forecasts. This assessment of uncertainty is reflected in the reported probability distributions of future inflation outcomes falling within given ranges. The panel comprises more than
70 professional forecasters located across the EU.
8
For the euro area is euro HICP excluding Tobacco.
6
In this paper, we abstract from disentangling inflation expectations from other risk premia. Several papers disentangle inflation expectations from inflation risk premium when
using market-based measures of inflation compensation, in particular for the US and the
Eurozone.9
We focus on the 5year-in-5year forward inflation swap rates, which reflect today’s expectations of inflation (plus risk premia) over a 5-year period beginning in 5 years’ time. They
are an usual reference of long-term inflation expectations for central banks as pointed out
by Draghi (2014): “[the 5year/5year swap] is the metric that we usually use for defining
medium term inflation”.
Figure 1 shows the dynamics of the 5year-in-5year forward inflation swap rates for the
US, UK, Japan, Australia, Sweden, and the Eurozone. While the 5year-in-5year swap rates
have remained fairly stable for the UK and Australia, they have declined substantially for
the US, Sweden, and the Eurozone. Figure 2 displays the 5year-in-5year swap rates only for
those countries and clearly shows the steep decline in the past two years.
We use the sample from December 2007 to December 2015 to have complete series for all
countries, but data are available since April 2004 for the Eurozone and the UK, since July
2004 for the US, since March 2007 for Japan, since May 2007 for Sweden.
2.2
VAR with long-run restrictions
In this paper, we analyze whether the decline in long-term market-based inflation compensation can be explained by the “secular stagnation” hypothesis, i.e. a global persistent
slowdown in the economic activity, or by an oil price shock.
Since “secular stagnation” is the result of series of shocks that have permanent effects on
the level of output, we use long-run identification restrictions as proposed by Blanchard and
Quah (1989). Long-run restrictions allow us to consider the accumulated effects of shocks
in the system. Imposing identifying restrictions permits to identify a subset of shocks that
9
Hördahl and Tristani (2014), using a joint model of macroeconomics and term structure, disentangle
inflation expectations from inflation risk premium when using market-based measures of inflation compensation for the US and the Eurozone. Pericoli (2012) uses instead a no-arbitrage affine Gaussian term structure
model. Moreover, it presents an exhaustive review of the literature.
7
have permanent effects on some variables, but not on others, and shocks that do not have
permanent effects on any variables.
We use a three-variable VAR model including industrial production (IP), oil prices and
5year-in-5-year forward inflation swap rates, in this order. The identification restriction used
allows us to identify only one shock with permanent effects on the long-run level of industrial
production, which we call the “secular stagnation” shock. The permanent effects of an oil
price shock to the level of oil prices can be justified by the structural changes in the oil
market that have made more likely that prices will remain low for long (see for example
Morse, 2016 and Dale, 2015).
We use the variables IP and oil prices in percentage changes. Since “secular stagnation”
is a global phenomenon we use the measure provided by the OECD and including all OECD
countries as a proxy for the global industrial production.10
Finally, the lag length of the VAR is chosen based on the Bayesian information criterion
(BIC). It selects two lags for every country in the sample except Australia, for which four
lags instead are selected.
3
Empirical Results
In this section, we describe the empirical results of our three-variable VAR.
3.1
VAR with long-run restrictions
Figure 3 shows the results for the euro area. On the top chart, we present the 5year-in-5year
forward inflation swap rates for the euro area (in red) and the historical decomposition
(in blue) when using only the “secular stagnation” shock. The “secular stagnation” shock
explains the downward trend in inflation expectations in the euro area, but not the deep
decline since the autumn 2014. In fact, only when we add the contribution of both the long
10
We repeated the exercise using also the IP measure provided by the OECD including only the European
Union countries, and the measure provided by the World Bank including all countries with similar results.
8
run permanent shock to IP and to oil prices (bottom chart), we are able to mimic the series
for the euro area.
Analogous results for the US are presented in Figure 4. The top chart shows that, also for
the US, the “secular stagnation” shock does not explain the recent drop in long-term inflation
compensation. However, the historical decomposition using both the long run permanent
shocks to IP and to oil prices (bottom charts) is able to replicate the series.
Figure 5 presents the results for Sweden. The top chart shows that, while a “secular
stagnation” shock can explain the downward trend in inflation expectations since autumn
2011, it is not able to explain the further reduction in inflation expectations in the past 18
months. Similarly as the US and the UK, only when considering the contribution of both
the permanent shock to the long run level of IP and the permanent oil price shock we are
able to mimic the original series for Sweden (bottom chart).
We have presented so far the results for the countries that presented a decline in medium
to long term inflation expectations. Now, we repeat, for comparison, the same exercise for
the countries in the sample with stable inflation expectations.
In Figure 6, the results for the UK are reported. They show that the “secular stagnation”
shock neither alone (top chart) nor in combination with a persistent oil price shock can
explain the behavior of UK inflation expectations.
Figure 7 shows the results for Australia. Although inflation expectations have remained
fairly stable, they have slid since 2014. The top chart shows that the “secular stagnation”
shock is not able to explain the recent decline in inflation expectations. Adding also the
oil price shock (bottom chart), we are able to explain the decline, although with a different
pattern.
Finally, Figure 8 presents the results for Japan. Japan present a completely different pattern than previous countries with increasing inflation expectations, although still extremely
low. Therefore, it is difficult to interpret the contribution of “secular stagnation” and oil
price shock.
Our preliminary conclusion is that a global slowdown is only a partial explanation of the
9
decline in the long-term measures of market based inflation compensation, and there is an
important increase in the sensitivity to oil prices shocks that are perceived as permanent.
It is important to notice that we analyze the impact on long-term inflation compensation
and we do not attempt to disentangle whether the effect is on inflation expectations or on
other risk premia.
3.2
Common Factor Analysis
In the previous section, we analyzed the impact of the “secular stagnation” shock and of
a persistent oil price shock for each single country in the sample. However, since “secular
stagnation” is a global phenomenon we would like to analyze whether long-term inflation
expectations for all countries are driven by common factors.
First, we analyze how much a common factor component drives the movements in inflation
expectations. We estimate a common factor model using the first principal component for
our sample of six OECD countries. In Figures 9, 10, and 11 present the series with the
common factor component for the US, the UK, and the Eurozone.
The first observation is that for the US the common factor component explains 63% of
the variance of the series, for the UK 49%, while for the EA is 91%. It is not surprising given
that a global factors have a major role in determining domestic inflation and Common factor
explains over 50% inflation variance in advanced economies as pointed out in Ciccarelli and
Mojon (2010) and Ferroni and Mojon (2014).
Our second observation, however, is that, unlike in the UK, in the US and in the Eurozone
long-term inflation compensations are below the common factor component, meaning that
a country specific factor weighs the series down.
Then, we estimate the VAR with long-run restrictions as in the previous section when
using the estimated common factor of long-term inflation expectations. Figure 12 presents,
in the top chart, the estimated common factor (in red) and the historical decomposition (in
blue) when using only the “secular stagnation” shock. As before, the “secular stagnation”
shock can explain the trend of the common factor, but only when adding also the permanent
10
shock to oil prices is possible to replicate the dynamics of the series.
[To be completed]
4
Conclusions
In this paper, we have analyzed the decline in the long-term inflation compensation for a
sample of six OECD countries. Many studies have linked this recent decline to the impact
of the drop in oil prices. Instead, we analyze the decline of long-term inflation expectation
in the context of “secular stagnation” as discussed by Summers (2015d).
We use a VAR model with long run restriction in order to identify a “secular stagnation”
shock. Using historical decomposition of long-term inflation compensation for the countries
in the sample. We show that for US, the euro area, Sweden, and to a lesser extent Australia, countries that experienced a decline in long-term inflation compensation, the “secular
stagnation” shock explains the downward trend in inflation expectations, but not the recent
decline. Only adding the contribution of both the long run permanent shocks to IP and to
oil prices, it is possible to explain it.
Our preliminary conclusion is that a global slowdown is only a partial explanation of the
decline in the long-term measures of market based inflation compensations, and there is an
important increase in the sensitivity to oil price shocks that are perceived as permanent.
This could be interpreted as a sign of de-anchoring of inflation expectation
It is important to notice that we analyze the impact on the long-term inflation compensation and we are not able to disentangle whether the effect is on inflation expectations or
on other risk premia.
[To be completed]
11
References
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Is There a Link?”, The Regional Economist, Federal Reserve Bank of St. Louis.
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[4] Ciccarelli, Matteo, and Juan Angel Garcı́a, 2015. “International spillovers in inflation
expectations”, ECB Working Paper Series No. 1857.
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and Statistics, 92(3): 524-535.
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Times, February 9.
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12
[11] European Central Bank, 2014. “Monthly Bulletin”, July.
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13
[23] Summers, Lawrence H., 2015b. “Demand Side Secular Stagnation”, American Economic
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Stabilizing Policy”, speech delivered at the Nineteenth Annual Conference of the Central
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14
Figure 1: 5year-in-5year Forward Inflation Swap Rates, 2007-2015
5
4
3
2
1
0
-1
-2
US
UK
Japan
Australia
Source: Bloomberg.
15
Sweden
Eurozone
Figure 2: 5year-in-5year Forward Inflation Swap Rates, 2007-2015
4
3.5
3
2.5
2
1.5
1
0.5
0
US
Sweden
Source: Bloomberg.
16
Eurozone
Figure 3: Eurozone: “Secular Stagnation” Shock (top), “Secular Stagnation” and
Oil Price Shocks (bottom)
4
3.5
3
2.5
2
1.5
1
0.5
0
Mar-08
Dec-08
Sep-09
Jun-10
Mar-11
Dec-11
Sep-12
Jun-13
Mar-14
Dec-14
Sep-15
Dec-14
Sep-15
Euro area 5years-in-5 years forward inflation swap, historical decomposition
Euro area 5years-in-5 years forward inflation swap
4
3.5
3
2.5
2
1.5
1
0.5
0
Mar-08
Dec-08
Sep-09
Jun-10
Mar-11
Dec-11
Sep-12
Jun-13
Mar-14
Euro area 5years-in-5 years forward inflation swap, historical decomposition
Euro area 5years-in-5 years forward inflation swap
17
Source: Bloomberg.
Figure 4: US: “Secular Stagnation” Shock (top), “Secular Stagnation” and Oil
Price Shocks (bottom)
4
3.5
3
2.5
2
1.5
1
0.5
0
Mar-08
Dec-08
Sep-09
Jun-10
Mar-11
Dec-11
Sep-12
US 5years-in-5 years forward inflation swap, historical decomposition
Jun-13
Mar-14
Dec-14
Sep-15
US 5years-in-5 years forward inflation swap
4
3.5
3
2.5
2
1.5
1
0.5
0
Mar-08
Dec-08
Sep-09
Jun-10
Mar-11
Dec-11
US 5years-in-5 years forward inflation swap, historical decomposition
18
Source: Bloomberg.
Sep-12
Jun-13
Mar-14
Dec-14
US 5years-in-5 years forward inflation swap
Sep-15
Figure 5: Sweden: “Secular Stagnation” Shock (top), “Secular Stagnation” and
Oil Price Shocks (bottom)
3
2.5
2
1.5
1
0.5
0
SWE 5years-in-5 years forward inflation swap, historical decomposition
SWE 5years-in-5 years forward inflation swap
SWE 5years-in-5 years forward inflation swap, historical decomposition
SWE 5years-in-5 years forward inflation swap
3
2.5
2
1.5
1
0.5
0
19
Source: Bloomberg.
Figure 6: UK: “Secular Stagnation” Shock (top), “Secular Stagnation” and Oil
Price Shocks (bottom)
4.5
4
3.5
3
2.5
2
1.5
1
0.5
0
UK 5years-in-5 years forward inflation swap, historical decomposition
UK 5years-in-5 years forward inflation swap
UK 5years-in-5 years forward inflation swap, historical decomposition
UK 5years-in-5 years forward inflation swap
4.5
4
3.5
3
2.5
2
1.5
1
0.5
0
20
Source: Bloomberg.
Figure 7: Australia: “Secular Stagnation” Shock (top), “Secular Stagnation” and
Oil Price Shocks (bottom)
5
4.5
4
3.5
3
2.5
2
1.5
1
0.5
0
Australia 5years-in-5 years forward inflation swap, historical decomposition
Australia 5years-in-5 years forward inflation swap
Australia 5years-in-5 years forward inflation swap, historical decomposition
Australia 5years-in-5 years forward inflation swap
5
4.5
4
3.5
3
2.5
2
1.5
1
0.5
0
21
Source: Bloomberg.
Figure 8: Japan: “Secular Stagnation” Shock (top), “Secular Stagnation” and Oil
Price Shocks (bottom)
1.5
1
0.5
0
-0.5
-1
-1.5
Japan 5years-in-5 years forward inflation swap, historical decomposition
Japan 5years-in-5 years forward inflation swap
Japan 5years-in-5 years forward inflation swap, historical decomposition
Japan 5years-in-5 years forward inflation swap
1.5
1
0.5
0
-0.5
-1
-1.5
22
Source: Bloomberg.
Figure 9: US: 5year-in-5year Forward Inflation Swap Rates and historical decomposition
4.5
4
3.5
3
2.5
2
1.5
1
0.5
0
Dec-07
Jul-08
Feb-09
Sep-09
Apr-10
Nov-10
Jun-11
Jan-12
Aug-12
5year-in-5year forward inflation swap rate
Source: Bloomberg.
23
Mar-13
Oct-13
May-14
Common Factor
Dec-14
Jul-15
Figure 10: UK: 5year-in-5year Forward Inflation Swap Rates and historical decomposition
4.5
4
3.5
3
2.5
2
1.5
1
0.5
0
Dec-07
Jul-08
Feb-09
Sep-09
Apr-10
Nov-10
Jun-11
Jan-12
Aug-12
5year-in-5year forward inflation swap rate
Source: Bloomberg.
24
Mar-13
Oct-13
May-14
Common Factor
Dec-14
Jul-15
Figure 11: Eurozone: 5year-in-5year Forward Inflation Swap Rates and historical
decomposition
4.5
4
3.5
3
2.5
2
1.5
1
0.5
0
Dec-07
Jul-08
Feb-09
Sep-09
Apr-10
Nov-10
Jun-11
Jan-12
Aug-12
5year-in-5year forward inflation swap rate
Source: Bloomberg.
25
Mar-13
Oct-13
May-14
Common Factor
Dec-14
Jul-15
Figure 12: Common Factor Analysis: “Secular Stagnation” Shock (top), “Secular
Stagnation” and Oil Price Shocks (bottom)
5
4
3
2
1
0
-1
-2
-3
-4
PC of 5years-in-5 years forward inflation swap, historical decomposition
PC of 5years-in-5 years forward inflation swap
PC of 5years-in-5 years forward inflation swap, historical decomposition
PC of 5years-in-5 years forward inflation swap
5
4
3
2
1
0
-1
-2
-3
-4
26
Source: Bloomberg.