Despite the huge number of economic data releases, assessing the true state of the economy is an ongoing struggle for the very simple reasons that data are released with a certain time lag. It is as looking at a temperature gauge to see how cold or warm it was several weeks ago. The challenge is even bigger when it concerns where the economy may be heading in the coming months or years. In this respect, indicators of long term expectations can be useful. One can think of survey based indicators (e g the survey of professional forecasters conducted by the ECB) but also of information inferred from financial market prices. One such indicator grew to prominence last year when Mario Draghi referred to it in his Jackson Hole speech about one year ago. It is the 5 year 5 year forward breakeven inflation rate. Derived from swap contracts, it is considered as a measure of long term inflation expectations (the market expectation for average inflation over 5 years within 5 years). Over the summer this indicator has been trending down in the Eurozone, fueling concerns that deflation worries are rising again and/or that the economy is losing steam. However, some of it may be related to the decline in oil prices (historically there is some correlation between the two) though financial market volatility could also play a role. The accompanying chart shows the standard deviation of daily returns of the Eurostoxx50 and the standard deviation of the Eurozone 5 year 5 year forward breakeven inflation. For both series a moving window of 20 daily observations has been used and subsequently a 3 month moving average has been applied to visualize the short term trend.

image chart 4 sept 2015

There seems to be some correlation between the two series, suggesting that increased (lower) stock market volatility is accompanied by increased (lower) long term expected inflation volatility. This would indicate that the short term swings reduce its use as a long term indicator.