The work uses a factor model, applied to inflation swaps and inflation options with different maturities, to study expected inflation and the inflation risk premium in the euro area. Compared to the existing literature, the model introduces the hypothesis that both long-term inflation and its volatility are variable over time and the estimate of expected inflation is anchored to forecasts based on surveys conducted by the ECB.
Expected medium-term risk-adjusted inflation was close to the ECB's target from 2010 to mid-2014; subsequently it showed a decrease, contained by unconventional monetary policy, which reached a low when the pandemic broke out in 2020; it has increased since mid-2021, reaching just over 2 per cent at the end of the year. The medium-term inflation risk premium was positive until 2014, negative since 2015, almost nil towards the end of 2021.
