How Likely Is an Inflation Disaster?

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