Inflation and inflation risks – why are they relevant?
Inflation has rarely held the market's attention so closely as it does today. We seem to stand on the cusp of a regime change, from the lowflation of the past decade to an unknown higher range. Though there is talk of a 'return to normal', lowflation coupled with unprecedented liquidity injections by central banks has in fact become the 'new normal' and markets have become accustomed to life support. Should central banks react according to their mandates, a new, higher inflation regime would hit institutions who have been relying on low cost credit, and could cause many of the so called 'zombie' companies to go under – and also challenge the sustainability of ever rising public debt stocks. Savers, who are facing an erosion of the purchasing power of their savings would rejoice longer-term when rates normalise, and retail banking would have a chance to return to a sustainable 'borrow and lend' model.
The likely level of this higher inflation regime and inflation expectations are thus critically important, and widely discussed[1]. If the spike in inflation does not trigger higher inflation expectations and second-round effects, policy makers and other economic agents can afford to look through it. Things will look very differently if rising inflation feeds through to longer-dated expectations, changing the underlying inflation dynamics.
In view of the 2% inflation targets by most major central banks, it will make a huge difference if underlying inflation settles again at levels closer to, say, 1% or 3%. And at times when inflation views diverge, so-called linear indications from inflation-linked bonds or swaps only tell half the story if the expected value is, say, at 2% while most people think the actual outcome is either below 1% or above 3%.
So indications of future levels are eagerly sought, and one popular method of obtaining probabilities of a rise to various levels has been the inflation options market. By using methods developed for liquidly traded option markets like equities or interest rates, it becomes possible to derive implied probabilities of inflation changes in the future from the prices of inflation options. We assess the value and robustness of these indications derived from inflation options, and show that while some parameters are stable and statistically valid, this is not the case for all.
[1] ECB blog – Inflation dynamics during a pandemic (here).
