INFLATION EXPECTATIONS: FROM INFLATION TARGETING TO BREAKEVEN INFLATION RATES

Abstract

This thesis aims to highlight the importance of inflation expectations from a macroeconomic and financial markets perspective, focusing on the Eurozone area. After almost a decade characterized by low inflation, the COVID-19 pandemic in 2020 and Russia’s invasion of Ukraine in 2022 contributed to a global rise in the inflation level. These events produced an impact on the estimation of inflation expectations. The first part of this research is focused on explaining the importance of inflation expectations in the framework of monetary policy, discussing the introduction and impact of inflation targeting as a monetary policy rule. The second part is centered on financial markets and market-based inflation expectations, derived from inflation-linked bonds and inflation swaps. Lastly, an empirical analysis of inflation-linked bonds and breakeven rates is carried out to test the so-defined “expectations hypothesis” on German and Italian government bonds. The expectation hypothesis states that the excess return of long-term bonds over comparable short-term ones should be constant over time. The research strongly rejects the expectation hypothesis applied to the two countries both at nominal and real level. The same result is achieved when the expectation hypothesis is tested jointly on the breakeven rate, that is, the spread between a nominal bond yield and a comparable inflation-linked real yield.