Navigating high inflation: Is the ECB's monetary anchor holding firm? A study of the impact of monetary policy shocks on inflation expectations.

Abstract

This thesis investigates the impact of monetary policy shocks on inflation expectations in the Euro Area. The relevance of this study lies in the current economic climate, where inflation has surged to levels not seen in decades, peaking at 10.7% in October 2022. We extend our analysis through late 2023, addressing a gap in literature by including the recent period of heightened inflation not yet investigated. Our research builds on the existing literature on high-frequency identification by examining financial market surprises in Overnight Index Swaps around monetary policy announcements to identify monetary policy shocks (following Altavilla et al., 2019). We then assess the impact of those shocks on inflation expectations across short, medium, and long-term horizons measured with different maturities of Inflation-Linked Swaps (ILS). Unlike traditional Vector Autoregressions (VAR), we employ Local Projections to track the impact of these shocks up to 30 days after the announcements. In the first block of our analysis, we find significant near-term declines in Inflation-Linked Swap rates following restrictive Target or QE shocks, in line with macroeconomic theory, while Timing and Forward Guidance shocks have mitigated effects. The second block refines these results by separating Timing and Forward Guidance shocks into Odyssean and Delphic components using the Poor Man’s Sign Restrictions of Jarociński and Karadi (2020), revealing that Odyssean Timing shocks align with theoretical expectations, while persistent positive responses to Odyssean Forward Guidance are still troubling. The third block introduces our new factor model resulting in the identification of Odyssean Timing, Odyssean Forward Guidance, and Delphic Path factors, which produce responses consistent with theory. Across all models, long-term inflation expectations do not react significantly to monetary policy shocks. This indicates a robust anchoring of long-term inflation expectations in the Euro Area, reflecting the credibility of the central bank’s commitment to maintaining price stability.