# Why does the European Central Bank use the 5y5y rate to measure inflation

I cannot understand why the 5y5y swap rate measures inflation. I can see how the floating rate somewhat measures the rate of interest rates which are related to inflation. However I cannot understand why this swap rate is the preferred way to measure (medium term) inflation expectations.

• Link is now broken – Marco Demaio Jun 14 '19 at 20:25

To answer your question you have to understand Eurozone fixed income market structure:

1. The ECB's mandate is to maintain price stability for the entire Eurozone. Other measures of inflation---for instance the difference between French fixed-rate OATs (Obligations Assimilables du Tresor) and OAT linkers---measure only regional inflation, and suffer potentially from artifacts related to low liquidity.

2. Capital mobility within the Eurozone is quite good. The EU banking sector dominates swaps trading volume, and the interest rate swaps market is extremely deep and liquid. Therefore the swaps rate reflects Eurozone wide term structure. What's more, fixed income traders tend to quote Euro pay issues' spreads off of swaps. They are the benchmark rate.

3. There are EFSF (European Financial Stability Facility) and ESM (Eurpoean Stability Mechanism) bonds which also price to reflect Eurozone-wide term structure. However these SPVs have not issued linkers, so it's impossible to use them to price inflation.

4. Some commenters here have forgotten their fixed-income math. You can price counterparty risk-free interest rate swaps directly from fixed term structure. This is because in an arbitrage free world Treasury curves reflect market participants expectations for forward rates and swap rates. Any answer that suggests that swaps compensate for premiums and risks that are not purely term-structure related is false.

5. Swap rates pre-Dodd-Frank/MIFID used to reflect bank credit risk. Now that they are centrally cleared in Swap Execution Facilities (SEFs), any credit risk associated with the swap is paid in margin, not as an interest rate premium.

6. The choice of term and tenor (5y/5y) is arbitrary. The Federal Reserve also uses 5y/5y forward breakevens.

I hope this clarifies that the 5y/5y inflation rate swap is the only sufficiently liquid measure of Eurozone-wide inflation.

• An interesting answer but am not sure how a swap can measure inflation at a more basic level? – Trajan Dec 3 '16 at 13:00
• @Jurassic. You're right, a plain vanilla interest rate swap wouldn't do it, but an inflation swap would. Investopedia has a good explanation of inflation rate swaps. This document the.earth.li/~jon/junk/kerkhof.pdf is also very thorough. – CAMELS Dec 3 '16 at 15:37

In an interest rate swap, two parties swap with each other the obligation to pay a fixed rate for the obligation to pay a floating rate. Because it concerns a simple swap of obligations, the rates must have equal present value for both parties. The market quotes the fixed rate, so this is the variable of interest.

Draghi may have been referring to one of two types of swap contracts: the 5-year/5-year interest swap or the 5-year/5-year inflation rate swap. The case of the 5-year/5-year inflation rate swap is simplest. Because the contracts trade at equal present values, a lower fixed rate implies lower expected inflation.

The case for the interest swap requires an additional assumption. Consider that interest rates consist of two components: a compensation for inflation rate risk, and a compensation for default (and possibly other) risks. This latter part is called the risk premium, and it also affects the quoted fixed rates. So in order to draw any conclusions about market inflation expectations on the basis of interest rate swaps, it is simplest to assume that the risk premium is constant. Of course this is not necessarily the case, and this assumption could be investigated by looking at the difference between the two different swap contracts.

Finally, I cannot be certain about why the ECB prefers this measure to any other measure of inflation expectations. But besides the fact that it is a market measure, the timing adds up: the 5 year swap starts in 5 years, so it is an indicator of inflation 5-10 years in the future.

• not quite sure why if the risk premium for bearing a floating rate is constant this must mean the market expects lower inflation. it doesnt seem to link to the first sentence in that paragraph. – Trajan Aug 20 '16 at 16:10
• Timo, I think it's related to Inflation swaps, a specific case of an interest rate swap. – An old man in the sea. Aug 20 '16 at 22:58
• @Jurassic - Constant risk premium is an additional assumption, so it does not follow from anything else. I'll update to make that clear. – user7935 Aug 22 '16 at 9:42
• @An old man in the sea - Possible, although Draghi does not mention inflation swaps. Regardless, the mechanism remains the same: if the quoted fixed rates on such swaps go down, the market expects less inflation. – user7935 Aug 22 '16 at 9:42

There's one way, albeit not from interest rates futures. From fisher's approximation $i=r+\pi^E$, and thus if I know the nominal interest rate from a regular government bond, and subtract the (real)interest rate of an inflation protected bond - like TIPS - we get the market's expected inflation forecast.

The key interest rate gives a direction on the cost of money. This rate influences the entire money supply and the cost of money for banking intermediaries.

This is the overall economy of an area that is influenced by the decisions of the monetary policy of the European Central Bank.

You have the right to ask questions of the economists of the European Central Bank directly on the website of this monetary institution. They are not obliged to respond.

When the interest rate is reduced, the central bank hopes to stimulate the economy by monetary irrigation.