The European Central Bank has published a working paper examining euro area inflation risks from 2009 to 2026 and how their variation across maturities can indicate whether markets view inflation shocks as temporary or persistent. The authors develop daily risk neutral inflation distributions for two-year, five-year and five-year forward inflation five years ahead using traded zero coupon inflation options and a Student’s t-copula. The findings represent the authors’ views and not necessarily those of the ECB. The estimates show that near-term inflation risks respond more sharply than long-term risks. In the first half of 2020, the risk neutral probability of deflation reached almost 70% at two years and 36% at five years, but remained below 7% for the five-year forward horizon, where low positive inflation was the main concern. The post-pandemic surge reversed the pattern, with almost all probability mass above 2% at the two-year and five-year horizons by spring 2022, while long-term risks rose less and later. Short- and medium-term risks were associated mainly with current inflation, confidence indicators, commodity prices and near-term macroeconomic risks, whereas long-term risks were more closely linked to price developments and monetary and financial conditions.
European Central Bank publishes research linking the inflation risk term structure to shock persistence
A European Central Bank working paper finds that inflation risk distributions across maturities can show whether markets view inflation shocks as temporary or persistent. Near-term euro area risks moved sharply during the 2020 deflation scare and the subsequent inflation surge, while five-year forward risks remained comparatively contained. Shorter-horizon risks were linked mainly to inflation, confidence and commodities, while longer-term risks were more closely associated with monetary and financial conditions.