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The European Central Bank on Thursday urged businesses in the eurozone not to use unduly pessimistic inflation scenarios in their financial planning.
“Euro-area longer-term inflation expectations have in recent years been well anchored at a level consistent with price stability,” despite a recent rise in the short-term inflation outlook, the central bank for the 12-member currency bloc said in its monthly report for July.
Jean-Claude Trichet, ECB president, has repeatedly cited expectations of price rises as a factor influencing the recent tightening of monetary policy. The bank’s main rate is 2.75 per cent and some analysts predict it could rise by 25 basis points in August.
Inflation expectations are vital for the economy because they influence the price at which a business is prepared to borrow funds or a bank is willing to lend money. They can also be a determining factor for long-term interest rates.
Giving an indication of the importance the ECB attaches to expectations of inflation and how they are tracked, the bulletin looked at how various economic surveys and financial securities are used to predict the speed of future price rises.
The Frankfurt-based institution looks at surveys of consumers and economists, as well as a range of financial instruments. The yield difference between a normal and inflation-linked bond can be used as a measure of price expectation.
“However, both types of measure…are only an imperfect measure,” the central bank warned, as human perceptions can be tinged by past events rather than current data and markets can react to more than inflation.
Consumer forecasts about price rises had proved faulty since the introduction of the euro, the central bank said, while economists were invariably caught out by “price shocks” such as unexpected surges in the oil price.
To make up for these deficiencies, the bank says it uses both measures in parallel and “cross checks” one against the other. In the past few years both have proved to be largely in line with the course of actual price rises.
The ECB sees this as a testament to the solidity of its monetary policy. “These findings…suggest that the ECB’s commitment to promoting price stability is viewed as credible, though there is no reason for complacency.”
This indicates the central bank is happy with the direction of its policy and sees no reason at present to veer from the course of small but repeated rate rises. Some analysts see rates reaching 3.5 per cent by year-end. In the July report, the bank repeated its view that progressive rate increases would be justified if the economic recovery in the eurozone continued.
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