Inflation risk term structure reveals persistence of price shocks
Euro area option prices show long-term inflation risks remained anchored between 2009 and 2026, even when two-year deflation probability reached 70 percent. ECB researchers modeled the term structure of risk-neutral densities using inflation caps, floors, and a Student's t-copula.
Divergence across maturities
Researchers combined non-parametric spline smoothing with a Student’s t-copula to extract risk-neutral probability distributions from euro area zero-coupon inflation options.
Across the 2009–2026 sample, pricing diverged sharply between horizons.
During the 2020 pandemic shock, the risk-neutral probability of outright deflation reached nearly 70 percent at the two-year horizon and 36 percent at five years, but stayed below 7 percent for the five-year forward rate five years ahead (5y5y).
Instead, more than 70 percent of 5y5y probability mass concentrated in the 0 to 1.5 percent range.
In the 2022 inflation rise, the balance of risks reached 0.98 at two years but only peaked at 0.42 for 5y5y in May 2023.
Cyclical drivers versus financial anchors
Stochastic search variable selection across 36 macro-financial indicators explains 95 percent of variation in the balance of risks.
Short-term distributions reflect cyclical factors, including headline inflation, purchasing managers' indices, commodity prices, and near-term growth expectations.
In contrast, five-to-ten-year risks load on different factors: producer price indices, survey expectations, interbank OIS spreads, credit spreads, and the slope of the United States yield curve.
A single maturity blinds policy
Relying on five-year point forecasts obscures the boundary between transitory price shocks and structural de-anchoring.
The methodology demonstrates that liquid options deliver robust risk densities without illiquid forward contracts.
Central banks must track the full term structure to prevent overreacting to near-term volatility.