How Likely Is an Inflation Disaster?

36 Pages Posted: 27 Apr 2022 Last revised: 28 Apr 2022

See all articles by Jens Hilscher

Jens Hilscher

University of California, Davis

Alon Raviv

Bar-Ilan University - Graduate School of Business Administration

Ricardo Reis

London School of Economics & Political Science (LSE); National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Date Written: April 26, 2022

Abstract

The prices of long-dated inflation swap contracts provide a much-used estimate of expected inflation at far horizons. This paper develops the methods to estimate complementary tail probabilities for persistently very high or very low inflation using the prices of inflation options. For the object of interest---inflation disasters at long horizons---we show that three adjustments to conventional measures are crucial: for real payoffs, risk, and horizon. Applying the method to the United States (US) and the Eurozone (EZ) we find that (i) the probability of US deflation in 2011-14 was not very high, (ii) the tail probability of a deflation trap in the EZ post 2015 has been high throughout in spite of varying policies meant to address this issue, as well as shocks, and (iii) there was a significant steady rise in 2021 in the risk of persistent high US inflation, and a sharp rise in 2022 in the EZ.

Keywords: option prices, inflation derivatives, Arrow-Debreu securities

JEL Classification: E31, E44, G13

Suggested Citation

Hilscher, Jens and Raviv, Alon and Reis, Ricardo A.M.R., How Likely Is an Inflation Disaster? (April 26, 2022). Available at SSRN: https://ssrn.com/abstract=4083404 or http://dx.doi.org/10.2139/ssrn.4083404

Jens Hilscher (Contact Author)

University of California, Davis ( email )

One Shields Avenue
Apt 153
Davis, CA 95616
United States

Alon Raviv

Bar-Ilan University - Graduate School of Business Administration ( email )

The Graduate School of Business Administration
Ana and Max Web st
Ramat Gan
Israel

Ricardo A.M.R. Reis

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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