Indicator variables for inflation expectations in the Euro area

Abstract

In this paper, we model the Euro area market-based inflation expectations extracted from the inflation-linked swaps, and study the macroeconomic information embedded in expected inflation. First, we estimate the Gaussian affine term structure model to decompose the forward ILS-implied inflation rate into inflation expectations and inflation risk premium at one-, two- and three-year horizons. Secondly, from a large panel of macroeconomic series we identify the most significant indicator variables for inflation expectations using the elastic net modification of the LASSO regression. Finally, we measure partial contributions of individual indicator variables to the changes in inflation expectations. Our findings reveal that across horizons considered inflation expectations are correlated to the measures of current inflation of the overall price level and price level of services, the unemployment rate, and the Euro exchange rate. The identified indicators provide a useful information about the evolution of inflation expectations with different intensities at different horizons.