22-Sep-23 Inflation

Are inflation expectations getting out of hand?

German inflation expectations now exceed those seen in the U.S. We explain why this seemingly alarming finding is fairly meaningless for European monetary policies.

Inflation expectations for Germany now exceed those anticipated by bond markets for the U.S.

Sources: Bloomberg Finance L.P., DWS Investment GmbH as of 9/20/23

We would not quite go that far. “The ECB has plenty of good reasons to lean against inflation. Following the latest interest rate hike, we think it will keep rates at current elevated levels, probably for quite a while. For how long will depend on incoming data. But market derived inflation expectations are only one of many measures they will be watching closely in coming months, and probably not particularly high up”, explains Ulrike Kastens, Senior Economist Europe at DWS.

For one thing, market inflation expectations have been quite volatile themselves.[1]For another, rational inflation expectations are useful theoretical constructs to come up with tractable models of how economies work. But postulating them is no substitute for actually looking at how wages and prices are set, or how expectations are formed in any particular country in the real world. How indexed bond contracts are structured and indexed, not to mention market liquidity, differ not just between the U.S. and Germany, but even within the Eurozone too. Different countries in the common currency area are also experiencing quite distinct dynamics, making transatlantic comparisons of small differences between the U.S. and one, admittedly important, country fairly meaningless for monetary policy. Finally, inflation itself is surprisingly hard to properly measure.[2] We are hopeful that the skilled economists at the ECB will know as much, realizing that markets are not always quite as rational and well-informed as some economic commentators appear to think.

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1. That not very surprising nor unusual for financial markets, especially when faced with hard to gauge or unusual developments. See, for example, Akerlof and Shiller, ibid. pp. 131-148. Or Surowiecki, J. (2005) “The Wisdom of Crowds: Why the Many are Smarter than the Few and How Collective Wisdom Shapes Business, Economics, Society and Nations”, Abacus, pp. 40-65

2. See: Sense and nonsense in inflationary times (dws.com) and Goodhart, C. and Pradhan, M. (2020). The Great Demographic Reversal: Ageing Societies, Waning Inequality and an Inflation Revival. Palgrave Macmillan. For further details, also see: Sense and nonsense in pandemic times (dws.com). Incidentally, the fact that inflation expectations are conceptually vital for current theories, but tricky to measure them a bit fluid intelligence in cognitive psychology. See Stanovich, K. (2010) “What Intelligence Tests Miss: The Psychology of Rational Thought”, Yale University Press, esp. pp. 45 – 69.

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