Working Paper: CEPR ID: DP17224
Authors: Jens Hilscher; Alon Raviv; Ricardo Reis
Abstract: Long-dated inflation swap contracts provide widely-used estimates of expected inflation. We develop methods to estimate complementary tail probabilities for persistently very high or low inflation using inflation options prices. We show that three new adjustments to conventional methods are crucial: inflation, horizon, and risk. An application of these methods finds: (i) US deflation risk in 2011-14 has been over-stated, (ii) ECB unconventional policies lowered the deflation disaster probability, (iii) inflation expectations deanchored in 2021-22, (iv) and reanchored as policy tightened, (v) but the 2021-24 disaster left scars, (vi) US expectations are less sensitive to inflation realizations than in the EZ.
Keywords: option prices; inflation derivatives; Arrow-Debreu securities
JEL Codes: E31; E44; G13
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Probability of US deflation in 2011-2014 (E31) | Misjudgment of deflation risks during that period (E31) |
| Tail probability of a deflation trap in the Eurozone post-2015 (E31) | Persistent risk of deflation (E31) |
| Notable increase in the risk of persistent high inflation in the US during 2021 (E31) | Contradiction of policymakers' assertions that inflation was temporary (E31) |