ECB: Change in Sign of Inflation Risk Premia May Reflect Anticipation of Further Supply Shocks
13 January 2022
By David Barwick – FRANKFURT (Econostream) – The recent increase in inflation risk premia based on inflation-linked swap (ILS) rates may be related to the risk that supply shocks will continue to batter the economy, the European Central Bank said on Thursday.
In a section of its eighth and last economic bulletin of 2021 devoted to ‘Decomposing market-based measures of inflation compensation into inflation expectations and risk premia’, the ECB said that the rise in forward ILS rates seen since the middle of 2020 was ‘attributable more to inflation risk premia than to inflation expectations’, suggesting that ‘the rise is mainly related to a shift in the inflation risks priced in, from lower than expected to higher than expected.’
ILS rates, the bulletin noted, serve as an indication of how much investors in the euro area need to be compensated for inflation and are thus of high interest to central banks. They plummeted in the immediate wake of the outbreak of the pandemic, rising again after March 2020.
‘Most recently, the one-year ILS rate has reached as high as 3%, but the one-year forward rate one year ahead has remained below 2%’, the bulletin commented. ‘This suggests that the financial markets are pricing the recent rise in inflation as transitory. Importantly for the medium-term objective of price stability, the five-year forward rate in five years ahead has returned to levels close to 2%.’
The two econometric term structure models used to break up ILS rates into expectations and risk premia indicated that the former were more stable than ILS rates, while risk premia, positive until around 2013-2014, had then turned negative, the ECB reported.
This, the ECB said, suggested ‘that markets increasingly accounted for the risk of inflation outcomes falling below their expectations.’
With the pandemic now fading somewhat, estimates of risk premia have climbed noticeably ‘and even changed sign to possibly become slightly positive again’, the ECB said. ‘This change in sign might be related to the pricing in of a greater likelihood, or at least risk, of the economy being dominated by supply shocks in the foreseeable future in the context of ongoing supply bottlenecks.’