Is the ECB’s aim of price stability still credible?

Is the ECB’s aim of price stability still credible?

An empirical examination of sovereign bond yields.

Alexander Kupfer

June 4, 2014

Abstract

Recent financial turmoil has provoked various bailouts and several support- ing activities in Europe by the EU, the IMF and the ECB. Using an event study, I investigate whether the ECB’s aim of price stability with an infla- tion rate of 2% is still credible despite the ECB’s various activities aimed at solving the sovereign debt crisis. During the crisis, especially one ECB announcement has a highly significant impact on sovereign bond yields in- dicating that investors did not expect this measure of the central bank.

Findings are in line with existing literature suggesting that unexpected ECB announcements have an impact on sovereign bond yields. Robust- ness checks confirm that this impact on bond yields might be affected by changing inflation expectations.

.

JEL classification: E44, E58, G01, G14

Keywords: ECB, price stability, credibility, financial crisis, sovereign debt crisis

∗An earlier version of this paper has been presented at the 20^th Annual Conference of the Multinational Finance Society. I thank Adrian Pop and an anonymous referee for pointing out potential improvements of the paper and Katrin Wibmer for a careful reading of the manuscript and helpful suggestions. The author gratefully acknowledges financial support from the University of Innsbruck and the Tiroler Wissenschaftsfonds.

†Department of Banking and Finance, University of Innsbruck (Austria). Tel.: +43 512 507 7583, E-mail: alexander.kupfer@uibk.ac.at

1 Introduction

The financial turmoil starting in 2007 and the subsequent sovereign debt crisis in Europe necessitated extensive rescue activities by European states. The Eco- nomic and Monetary Union (EMU) of the European Union seems to be most affected by the crisis, as reflected e.g. in the haircut in Greece, several bailouts of other countries (e.g., Spain, Portugal, Ireland) or the extensive support of Eu- ropean financial institutions. Essential rescue actions are mainly conducted by the European Union itself, as well as by the European Central Bank (ECB).¹

The ECB’s rescue activities and increasing debt levels throughout Europe give rise to serious concerns regarding possibilities to lower these enormous amounts of debt in the future. According to Alesina & Ardagna (2010), spending cuts are more suitable than tax increases in order to lower the budget deficit as well as the debt-to-GPD ratio. However, the current situation implies that spending cuts on an overall European level are quite unlikely since they could stifle economic growth. Another possibility at least partially to lower the debt burdens are increasing inflation rates. Higher inflation rates will reduce the real value of debt and, consequently, lower the debt-to-GDP ratio. Although Missale & Blanchard (1994) caution against the use of this possibility since it may result in a loss in credibility as a borrower, several economists now plead for a higher inflation rate within the Eurozone (Krugman (2011); Rogoff (2011); Blanchard et al. (2010)).

In addition, Aizenman & Marion (2011) discuss the use of this option for a reduction of the US debt level. While the Federal Reserve (Fed) in the United States focus on maximum employment, stable prices, and moderate long-term interest rates in their monetary policy objectives (12 USC ˆA§ 225a), the ECB’s main task is to maintain price stability with an inflation rate close to 2%. This results in discussions about higher inflation rates being of a relatively higher importance in the Eurozone due to the ECB’s statutes.²

1See e.g. Belke (2010) for an overview of the ECB’s activities in the financial and debt crisis.

2An ongoing discussion about the existing and future activities to rescue the Eurozone already takes place: On the one hand, even more actions within the Eurozone are demanded, such as a more closely integrated European economy, increasing guarantees of stronger member countries as well as a more active ECB (see e.g. Valiante (2011) or De Grauwe (2011)). On the other hand, there are arguments claiming that especially the ECB has already exceeded its field of functions with the purchase of government bonds and its Target 2 imbalances, and that the ECB is neglecting its key task of maintaining price stability (see e.g. Bernholz (2012) or Sinn (2010)).

1

Given the aforementioned discussion regarding the possibility to lower debt burdens - at least to some extent - via higher inflation rates, concerns with respect to the ECB’s goal of maintaining price stability with an inflation rate of 2%

may rise. Whether these concerns are substantial or not depends on investors’

perception regarding the ECB’s credibility. Given the importance of this issue, this paper’s research interest consists in an investigation of whether the ECB is still credible regarding the maintenance of price stability. The paper aims to analyze ECB’s credibility by observing investors’ inflation expectations, which are derived from the Fisher equation. The Fisher equation as the basis for the analysis of changing inflation expectations implies that nominal bond yields contain the real interest rate plus the expected inflation. I apply an event study approach which allows for the investigation of immediate effects of ECB announcements concerning certain rescue activities on sovereign nominal bond yields, since an increase (decrease) in inflation expectations also leads to an increase (decrease) in nominal bonds yields. The analysis is based on financial market prices instead of inflation surveys or expert opinions and thus allows to capture announcement’s immediate effects with less subjectivity.

By analyzing government bond yields of Eurozone countries with liquid finan- cial markets that are not directly affected by the sovereign debt crisis (i.e., France and Germany), I find that one specific ECB announcement (i.e., the ECB press conference to announce the purchase of sovereign bonds), which was an unex- pected and surprising announcement for investors, has a significant and positive impact on sovereign bond yields, indicating that inflation expectations increased.

The use of sovereign CDS spreads and European inflation swaps in robustness checks confirms the hypothesis of a change in investors’ inflation expectations on this specific event day. The significant shift of inflation expectations suggests investors’ increasing mistrust regarding the ECB’s aim of price stability and a loss of its credibility at least on that specific announcement day.

The paper is structured as follows: Section 2 presents an overview of existing literature analyzing the sovereign debt crisis and particularly the ECB’s role.

Section 3, including the empirical analysis, describes the underlying data and methodology and discusses the results. Finally, section 4 concludes.

2 Literature overview

According to Shambaugh (2012), the European Union faces three ’interlocking crises’ challenging its common currency and members. There is a banking crisis, a sovereign debt crisis and a growth crisis, which necessitate rescue activities and bail-outs. The ECB has developed an active role in this respect by launching several rescue activities. Studies regarding the current situation of the ECB conclude that the central bank acts as a lender of last resort (Eichler & Hielscher (2012)), is exposed to substantial credit risk due to the purchase of government bonds (Gerlach (2010)), is considerably endangered due to its Target 2 imbalances (Sinn & Wollmersh¨auser (2011)) and is generally at risk to lose it’s independency (see e.g. Weber & Forschner (2014); Taylor (2010)).³ However, the majority of academic as well as journalistic literature reviews the ECB’s activities during the crisis (see e.g. Reichlin (2014); Pattipeilohy et al. (2013)) or discusses its future functions regarding monetary as well as fiscal policies (see e.g. Eijffinger

& Hoogduin (2012); De Grauwe (2011); Feldstein (2011)).

Studies regarding the effects of ECB announcements include Lamla & Lein (2011), which analyze how ECB announcements influence financial markets and Beirne et al. (2011), which investigate the effectiveness of the ECB’s covered bond purchase programme on money market term rates, credit conditions and market liquidity. Horvath & Huizinga (2011) as well as Kilponen et al. (2012) focus on specific announcements and activities during the financial crisis. While Horvath & Huizinga (2011) examine the impact of announcements concerning the European Financial Stability Facility on bank share prices and CDS spreads, Kilponen et al. (2012), in a study similar to this one, analyze the effects of ECB policies during the crisis. More specifically, the authors study policy decisions by different authorities during the sovereign debt crisis in Europe and analyze the activities’ impact on sovereign bond yields of seven Eurozone countries. They find significant effects of different policy activities and argue that especially the announcement of the ECB’s security market programme to buy sovereign govern- ment bonds has ’the strongest immediate stabilizing effect on the bond yields’

(Kilponen et al. (2012, p. 19)). The negative impact on German bond yields,

3Geraats (2008) argues that the general credibility of the ECB was quite high until the beginning of the financial crisis but Gros & Roth (2010) find that trust in the ECB has been considerably decreasing since the financial turmoil.

however, was only significant one day after the announcement day and at the announcement day, the effect on German bond yields was even positive and sig- nificant. While the finding of a positive and significant effect at the announcement day for German bond yields is line with the findings in this paper, the interpreta- tion of the result is quite opposite: Kilponen et al. (2012) read the negative effect one day after the announcement day as a stabilization and do not connect this finding with inflation expectations, I, on the other hand, read the positive effect at the announcement day as a possible sign for changing inflation expectations (see section 3.4).

Furthermore, inflation expectations within the Eurozone are examined rather in course of the EMU’s development than in the current crisis situation. These earlier studies find that inflation expectations are anchored due to the strong credibility of the ECB (Van der Cruijsen & Demertzis (2011); Demertzis et al.

(2009)) and that the Eurozone has led to a decreasing trend in inflation and to lower inflation uncertainty in Europe (Caporale & Kontonikas (2009)). To the best of the author’s knowledge, only the study by Galati et al. (2011) analyzes inflation expectations during the financial crisis. The authors compare market implied inflation measures (i.e., inflation-linked bond yields and inflation swap rates) with survey-based inflation measures in the long run and find structural breaks during the crisis for United States, the United Kingdom and the Eurozone.

While the combination of market measures and survey-based measures could lead to ’difficulties in measuring expectations accurately’ (Galati et al. (2011, p. 201)), the analysis in this paper only relies on market measures and heterogeneities in expectation formation are negligible.

This paper combines the analysis of policy announcements’ effects with the ex- amination of inflation expectations by studying market-based inflation measures on ECB announcement days. More specifically, I analyze ECB announcements regarding its policy activities during the crisis with regard to its credibility to maintain price stability with an inflation rate close to 2%. The following sec- tion describes the event study approach, which evaluates sovereign nominal bond yields during important ECB announcements, its underlying data as well as the results.

3 Event study

The financial crisis is characterized by various market disturbances such as high liquidity premia for illiquid assets or so called ’flight-to-quality’ or ’flight-to- liquidity’ effects.⁴ Bond yields might also be distorted by one or more of these effects and an appropriate analysis is rather difficult. More specifically, Svensson’s (1993) test of inflation target credibility, for instance, is impossible to apply due to these distorting effects on sovereign bond markets.⁵ An event study approach, however, is able to examine investors’ immediate reactions to ECB announce- ments via changes in sovereign bond yields. In the following sections, I present the study’s methodology, underlying data as well as the results of the analysis.

3.1 Methodology

The basic assumption of an event study is that all available information is im- mediately incorporated in the market price. If new and relevant information is released during a press conference, for instance, this reference should have an immediate effect on market prices. An event study approach is therefore an appropriate tool for analyzing the effects of announcements under (at least semi- strong) market efficiency. The basic idea is to isolate a particular event and to subsequently analyze its direct impact (see e.g. Campbell et al. (1996) for an overview of the event study methodology).

The main idea of this event study is based on the Fisher equation implying that nominal bond yields consist of real interest rates plus inflation expectations.⁶ Analyzing nominal bond yields during important ECB announcements allows to capture changes in inflation expectations that are not based on inflation surveys

4Beber et al. (2009) analyze the impact of ’flight-to-quality’ and ’flight-to-liquidity’ effects during the European sovereign debt crisis. These effects can most simply defined as investors’

run on save or liquid assets during, for instance, a financial turmoil, leading to a strong price increase of these assets. Simultaneously, the prices of insecure or illiquid assets will decrease.

5The test of Svensson (1993) is a long-run analysis of government bond yields but is not feasible during times of financial turbulence since yields might contain time variable risk premia (e.g., liquidity premia). Differences in analyzed bond yields might thus not only represent a change in central bank’s credibility, but also the presence of diverse risk premia. See Svensson (1993) for further information.

6The exact formula for the Fisher equation is i = r + π^e+ (r× π^e). However, for very low values, the last term becomes extremely small and can be ignored. The Fisher equation is thus generally reduced to i = r + π^e, where i is the nominal interest rate, r the real interest rate and π^e the inflation expectations (see e.g. Mishkin (2001).

or expert opinions but rather on financial market prices: An increase (decrease) in inflation expectations also leads to higher (lower) nominal bonds yields. The paper’s hypotheses are therefore stated as follows:

H₀: ECB announcements regarding rescue activities have no signif- icant effect on German and French nominal bond yields.

H₁: ECB announcements regarding rescue activities have a signifi- cant effect on German and French nominal bond yields.

The analysis of investors’ inflation expectations during important announce- ments of the ECB investigates whether investors still trust the central bank’s aim of price stability or not. A significant unexpected change in bond yields would therefore indicate a change in inflation expectations and subsequently a change in the central bank’s credibility. In order to analyze whether bond yield changes are significant on the selected event days, I follow the methodology of Swanson (2011), who investigates the effects of Operation Twist - a quantitative easing program by the Federal Reserve in the United States in the 1960s. The author uses US Treasury bond yields for different maturities to analyze the effects of the announcements concerning the quantitative easing. In contrast to Swanson (2011), who averages yield changes from a basket of outstanding bonds with the the same maturity, I use generic bond data provided by the Bloomberg database.

The advantage of the generic data is that these yields are solely composed of on-the-run bonds, which are always the most current issues.

To test for statistical significance, I derive - in line with Swanson (2011) - the unconditional standard deviation of the yield changes for the current year and the specific maturity, and the ratio of the yield response on an event day relative to the respective unconditional standard deviation. As a result, a two-sided t test can be applied to check for significance.⁷

7Recently, Bessembinder et al. (2009) analyze the methodology of corporate bond event studies and find that the power and specification of test statistics varies considerably among different study designs. They suggest using trade-weighted prices rather than noisy last prices in order to improve the tests’ specification and power. Bessembinder et al. (2009) use the TRACE database, which includes all secondary market transactions in traded US corporate bonds, to calculate trade-weighted prices. Such comprehensive transactions data, however, is not available for Eurozone sovereign bond markets, and only available in weekly frequency for US primary dealers’ transactions. However, Andres et al. (2013) perform a similar analysis as Bessembinder et al. (2009) for CDS spreads and argue that, in general, the usage of factor models and the application of non-parametric tests results in the highest power of the test

3.2 Data

For testing the hypotheses proposed in section 2, sovereign bond yields are ex- tracted for countries that (i) are members of the Eurozone, (ii) have a relatively strong impact on the European Union as a whole and (iii) are not directly affected by the current sovereign debt crisis through bail-outs or the announcements of bail-outs. Given these constraints, I use German and French bond yields for the analysis below since, for instance, yields of Spanish or Italian bonds are directly affected by announcements of the ECB to buy their bonds on the secondary market. Moreover, UK bond yields cannot be employed since the UK is not a member of the Eurozone. Finally, also bond yields of smaller countries within the Eurozone of the European Union are not a proper benchmark for the entire Eurozone.

More specifically, German and French nominal generic bond yield data for 13 different maturities is used (i.e., 1 to 10 years, 15 years, 20 years and 30 years).

For all maturities, daily yield changes are calculated and the yields response on announcement days is investigated. Preceding the respective analysis, important and relevant announcements of the ECB with respect to its rescue activities in the sovereign debt crisis will be identified.

3.3 Identification of relevant events

Concentrating on important and relevant activities of the ECB during the sovereign debt crisis, the following two categories of events are identified: (i) announcements related to the purchase of sovereign bonds and (ii) announcements related to the support of bank lending and money market activity. While the first category is directly linked to the rescue activities of countries that were severely affected by the debt crisis, the second category only has an indirect but considerable impact on the rescue activities: The implementation of two tenders with a maturity of three years is a substantial activity of the ECB in order to sustain Europe’s banking market and to prevent an aggravation of the sovereign debt crisis.

statistics. Nonetheless, the authors note that if a factor model is impossible due to data availability, mean-adjusted models will only perform slightly worse than a non-parametric test using a factor model.

(i) Announcements related to the purchase of sovereign bonds

The purchase of sovereign bonds by the ECB is based on the securities market programme (SMP) started in May 2010. Within this policy, the ECB purchased government bonds of Eurozone countries for about 220 billion Euro until October 2012, thus indicating the importance of the tool to react during the crisis. On September 6, 2012, the current president of the ECB, Mario Draghi, announced the launch of the new outright monetary transactions (OMT) program, which holds the mandate for unlimited purchases of bonds of Eurozone countries in trouble. A detailed overview of the ECB’s activities regarding the SMP and the OMT can be found in the Appendix. It is important to note, however, that the ECB aims to sterilize all the bond purchases in order to hold money supply constant and to not influence monetary policies. The identified announcements are summarized in Table 1, including a short description of the announcement as well as the expected effect on yields (assuming that yield changes reflect the inflation expectations of investors).

Date of

Announcement Description Event window Expected effect

on yields May 10,

2010

ECB press conference to launch the SMP, including the purchase of Greek government bonds

1-day change

May 7-10, 2010 increase

August 7, 2011

ECB press conference to extend the SMP to additionally buy Spanish and Italian government bonds

1-day change

August 5-8, 2011 increase

September 6, 2012

ECB press conference regarding the launch of the OMT (unlimited bond-buying)

1-day change

September 5-6, 2012 increase

Table 1: Summary of important announcements related to the purchase of sovereign bonds by the ECB.

Source: ECB Website. Notes: ’Expected effects on yields’ describes the yield change assumed under the respective alternative hypothesis, with the null of un- changed inflation expectations rejected. Following sovereign bond purchases, in- vestors’ doubts regarding the maintenance of inflation close to 2% rise, which is - based on Fisher (1930) - reflected in increasing bond yields.

(ii) Announcements related to the support of bank lending and money market activity

Activities concerning the support of bank lending and money market activity are summarized under the term longer-term refinancing operations (LTROs). In order to support financial institutions and foster money market activity in the sovereign debt crisis, on December 8, 2011, the ECB announced a LTRO includ- ing two tenders with a maturity of 36 months at an interest rate of 1% (ECB (2011b)). Information about the total amount was announced on December 22, 2011, for the first run of the LTRO and on March 3, 2012, for the second run, respectively. Despite the lack of a direct connection between these activities and the rescue activities concerning a sovereign, investors might nevertheless consider these activities as a potential risk on the ECB’s price stability aim. The following Table 2 summarizes the announcements concerning the LTRO with a maturity of 36 months. Note that LTROs with a maturity of only 12 months are not included in the analysis below, since they are generally conducted with no specific focus on the financial crisis.

Date of

Announcement Description Event window Expected effect

on yields December 8,

2011

ECB press conference regarding the new LTROs and their conditions

1-day change

December 7-8, 2011 increase December 21,

2011

ECB announcement regarding the amount of the first tender

1-day change

December 20-21, 2011 increase February 29,

2012

ECB announcement regarding the amount of the second tender

1-day change

February 28-29, 2012 increase

Table 2: Summary of important announcements related to the support of bank lending and money market activity.

Source: ECB Website. Notes: ’Expected effects on yields’ describes the yield change assumed under the respective alternative hypothesis, with the null of un- changed inflation expectations rejected. Due to the enormous amount of the tender, investors’ doubts regarding the maintenance of inflation close to 2% rise, which is - based on Fisher (1930) - reflected in increasing bond yields.

3.4 Results

Table 3 shows the estimated impact on bond yields around ECB announcements for German government bonds. The announcement on May 10, 2010, has a sta- tistically significant and positive impact on German bond yields for all maturities tested. On this date, the ECB’s president, Jean-Claude Trichet, announced the decision to buy sovereign bonds to ’ensure depth and liquidity in those market segments which are dysfunctional’ (ECB (2010b)). The yields for all bond ma- turities increase considerably on this date, which could indicate a change (i.e., a rise) in investors’ inflation expectations. The announcement on August 7, 2011, on the other hand, which included the ECB’s decision to also buy Italian and Spanish government bonds, does not have a significant impact on German bond yields. The latest announcement on September 6, 2012, again shows a significant and positive impact for eleven maturities of German bonds. On the contrary, an- nouncements concerning the LTRO have no significant effects on German bond yields, indicating that investors do not have serious concerns about the financial institutions and do not expect expensive rescue activities of the ECB to lead to higher future inflation rates.

The same analysis for French bond yields is shown in Table 4. The announce- ment on May 10, 2010, is again significant for eight maturities, which supports the hypothesis of a change in investors’ inflation expectations. Note that the statistically significant yield changes are located in the long end of the matu- rity band, indicating that the announcement matters in the long-run but not in the short-run. All other announcements concerning the purchase of government bonds are insignificant, however, the first announcement regarding the support of bank lending and money market activity has a significant effect on yield series for six out of thirteen maturities. The fact that only French bond yields are influenced by the announcements on the LTRO may suggest that investors do not have concerns on expected inflation but rather on other sovereign specific- characteristics (e.g., weaker financial institutions in France than in Germany).

Overall, the results of this analysis provide evidence for both German and French government bonds exhibiting a significant and positive yield change after the first announcement of the ECB. Figure 1 resumes the effect of this event for the two countries and all maturities. The magnitude of the yield changes increases with maturity, which could indicate that - given there is a constant

Maturity 1year2years3years4years5years6years7years8years9years10years15years20years30years (i)announcementsrelatedtothepurchaseofsovereignbonds estimatedresponsestoECBannouncements(inbp) 1-daychangeMay7-10,20104.0∗7.0∗10.0∗∗12.2∗∗14.0∗∗∗15.0∗∗∗15.1∗∗∗16.2∗∗∗15.9∗∗∗15.8∗∗∗17.0∗∗∗17.3∗∗∗19.7∗∗∗ 1-daychangeAugust5-8,2011−6.8−4.2−4.7−5.6−6.4−7.0−7.5−8.1−8.7−8.5−8.0−6.6−4.2 1-daychangeSeptember5-6,20121.04.9∗∗6.5∗∗8.1∗∗8.7∗9.0∗8.8∗8.6∗8.6∗8.010.1∗∗10.0∗∗10.3∗∗ (ii)announcementsrelatedtothesupportofbanklendingandmoneymarketactivity estimatedresponsestoECBannouncements(inbp) 1-daychangeDecember7-8,2011−0.2−2.3−3.6−4.7−6.5−7.3−7.9−8.3−8.8−8.7−3.6−2.8−3.1 1-daychangeDecember20-21,20111.521.50.7−0.1−0.8−1.5−1.7−1.9−2−1.1−0.20.4 1-daychangeFebruary28-29,2012−2.9∗∗−0.9−1.01.92.92.62.12.31.41.81.81.82.0 unconditionalstandarddeviationofyieldchanges 20102.2%3.6%4.3%4.4%4.6%4.9%4.8%4.7%4.6%4.5%4.4%4.5%4.7% 20114.3%5.9%6.2%6.6%6.9%6.7%6.6%6.5%6.4%6.4%6.3%6.0%6.0% 20121.4%2.3%3.0%3.8%4.5%4.7%4.9%5.0%5.1%5.1%5.0%5.1%5.1% Table3:GermanbondyieldchangesandestimatedimpactaroundECBannouncements. Source:Bloombergandowncalculations.Note:Asterisksindicatestatisticalsignificanceforatwo-sidedttestatthe∗ 10percent, ∗∗5percentand∗∗∗1percentlevel.Significanceisrelativetotheunconditionalstandarddeviationofyieldchangesinthecurrent year.

Maturity 1year2years3years4years5years6years7years8years9years10years15years20years30years (i)announcementsrelatedtothepurchaseofsovereignbonds estimatedresponsestoECBannouncements(inbp) 1-daychangeMay7-10,20100.14.44.56.66.88.7∗∗8.0∗∗8.3∗∗7.6∗∗7.4∗9.5∗∗12.6∗∗∗13.2∗∗∗ 1-daychangeAugust5-8,2011−6.51.2−2.3−2.3−0.8−2.9−0.9−2.6−2.2−0.60.40.4−0.4 1-daychangeSeptember5-6,20120.72.73.12.62.61.72.32.72.61.92.03.43.4 (ii)announcementsrelatedtothesupportofbanklendingandmoneymarketactivity estimatedresponsestoECBannouncements(inbp) 1-daychangeDecember7-8,20110.77.110.11116.5∗∗14.6∗∗14.4∗∗13.4∗∗13.6∗∗13.8∗∗6.15.05.2 1-daychangeDecember20-21,20114.11.71.40.50.41.11.82.93.12.2−0.4−1.8−1.3 1-daychangeFebruary28-29,2012−2.3−4.3−7.0∗−7.0−4.4−3.4−3.9−4.8−5.0−5.5−4.9−3.9−3.2 unconditionalstandarddeviationofyieldchanges 20102.1%3.7%4.4%4.0%4.4%4.0%4.0%3.9%3.9%3.8%3.9%4.0%4.2% 20114.6%6.8%7.0%7.1%7.3%7.0%6.7%6.5%6.5%6.4%6.1%6.0%6.0% 20122.0%3.9%4.1%4.6%4.9%4.7%4.7%4.6%4.6%4.6%4.6%4.4%4.4% Table4:FrenchbondyieldchangesandestimatedimpactaroundECBannouncements. Source:Bloombergandowncalculations.Note:Asterisksindicatestatisticalsignificanceforatwo-sidedttestatthe∗ 10percent, ∗∗5percentand∗∗∗1percentlevel.Significanceisrelativetotheunconditionalstandarddeviationofyieldchangesinthecurrent year.

term premium - expected inflation including inflation risk premium is low in the short-run but high (and more relevant) in the long-run.

Given the significant yield changes of German and French government bonds after the important ECB announcement to start buying sovereign bonds demon- strated above, I argue that for almost all maturities, these yield changes originate from a change in investors’ inflation expectations due to a loss in the ECB’s credi- bility regarding the maintenance of price stability in the Eurozone. However, this significant impact can likewise indicate an increasing credit risk premium, which could also be included in bond yields. Therefore, robustness checks are necessary to properly analyze the implications of these significant yield changes. First, the findings are verified by using inflation swaps as another measure for inflation expectations and second, credit default swap (CDS) spreads are investigated in order to check for changes in the credit risk premium.

3.5 Robustness checks

As a first robustness check, I perform a similar event study based on European inflation swaps, which are financial securities to hedge against a change in infla- tion rates. More specifically, daily Eurozone HCPI inflation swap rates exist for a comprehensive band of maturities and are available in the Bloomberg database.

I calculate daily swap rate changes for all maturities and run the same statistical tests as in the previous section. A positive change in inflation swap rates repre- sents an increase of market implied inflation expectations for the Eurozone as a whole. Statistical significance is again tested with a two-sided t test. The results of this robustness check are shown in Table 5 below.

The original findings of the event study with French and German nominal bond yields are confirmed: Inflation swap rate changes during the first event on May 10, 2010, are significant and positive for all maturities and share a similar magnitude, thus being equivalent to the significant bond yield changes in the analysis before. Similarly, all other event days exhibit insignificant effects over the entire maturity band of European inflation swaps rate changes.

From an investor’s point of view, higher nominal bond yields as detected on one specific ECB announcement can originate from a change in inflation expecta- tions and thus indicate a loss of the ECB’s credibility regarding the maintenance of price stability in the Eurozone (i.e., inflation rates close to 2%). Nonetheless,

Maturity 1year2years3years4years5years6years7years8years9years10years15years20years25years30years (i)announcementsrelatedtothepurchaseofsovereignbonds estimatedresponsestoECBannouncements(inbp) 1-daychangeMay7-10,201014.8∗∗11.2∗∗∗13.0∗∗∗12.0∗∗∗12.4∗∗∗12.2∗∗∗11.5∗∗∗11.4∗∗∗11.2∗∗∗9.7∗∗∗9.7∗∗∗9.5∗∗∗8.1∗∗∗6.4∗∗∗ 1-daychangeAugust5-8,2011−10.5−13.0∗∗∗−5.5−3.5−6.5∗−5.0−5.0∗−1.0−1.5−4.7−1.8−1.01.5−1.8 1-daychangeSeptember5-6,20120.0−1.8−0.7−1.6−0.6−2.0−0.2−2.1−2.1−0.8−0.3−0.2−0.10.0 (ii)announcementsrelatedtothesupportofbanklendingandmoneymarketactivity estimatedresponsestoECBannouncements(inbp) 1-daychangeDecember7-8,2011−3.2−2.9−1.4−3.1−2.9−1.4−2.5−1.7−0.7−1.0−3.9−4.8∗−4.2−2.3 1-daychangeDecember20-21,20110.51.00.30.30.40.42.20.40.53.30.22.33.51.8 1-daychangeFebruary28-29,2012−0.5−0.2−0.50.0−0.2−0.3−0.2−0.3−1.3−0.4−1.5−1.3−0.6−0.7 unconditionalstandarddeviationofswapratechanges 20106.8%3.1%2.8%2.6%2.6%2.7%2.4%2.3%2.1%2.1%2.3%2.3%2.5%2.2% 20118.1%4.8%4.3%3.8%3.4%3.6%3.0%3.0%2.9%3.1%2.8%2.7%2.9%2.6% 20124.5%3.4%3.0%2.7%2.4%2.6%2.3%2.5%2.4%2.1%2.2%2.2%2.2%2.2% Table5:EventdayEurozoneHCPIinflationswapratechangesandestimatedimpactaroundECBannouncements. Source:Bloombergandowncalculations.Note:Asterisksindicatestatisticalsignificanceforatwo-sidedttestatthe∗ 10percent, ∗∗5percentand∗∗∗1percentlevel.Significanceisrelativetotheunconditionalstandarddeviationofdailyswapratechangesin thecurrentyear.

0 4 8 12 16 20

1 year 2 years 3 years 4 years 5 years 6 years 7 years 8 years 9 years

10 years 15 years 20 years 30 years

German bond yield changes on May 7-10, 2010 French bond yield changes on May 7-10, 2010

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yield change in basis points

Figure 1: German and French bond yield changes on May 7-10, 2010, for different maturities.

Source: Bloomberg and own calculations. Note: Asterisks indicate statistical significance for a two-sided t test at the ^∗ 10 percent, ^∗∗ 5 percent and ^∗∗∗ 1 percent level. Significance is relative to the unconditional standard deviation of yield changes in the current year.

changes in bond yields can also simply reflect an increase of credit risk. The comparison with European inflation swap rates has strengthened the argument towards a change of inflation expectations so far. Nonetheless, a second robust- ness check using CDS spreads is used to clarify whether credit risk has changed on this specific event day, too.

I extract five and ten year CDS spreads for France and Germany as well as for the so called GIIPS countries (i.e., Greece, Ireland, Italy, Portugal and Spain).

Using French and German CDS spreads, I test whether daily spread changes exhibit a significant positive movement on the event days indicating that their specific, sovereign credit risk was influenced by the ECB’s announcements. On

the other hand, no significant positive movement of German and French spread changes implies that the significant changes of nominal bond yields (as shown in the previous section) are due to a change in inflation expectations. Additionally, I include CDS spreads of the GIIPS countries to analyze the announcements’

impact on the affected countries. I focus on the same set of events and conduct the same analysis as before to test for statistical significance.

The results of this exercise are shown in Table 6. First and most impor- tantly, French and German CDS spread changes on the first event date are not significantly positive - in contrast, they exhibit a negative impact and are, in the case of Germany, even significant. Furthermore, the other event dates produce interest results, since two of them have a significant and positive impact on CDS spreads, implying that investors might expect higher (sovereign) credit risk due to these announcements. More specifically, French and German CDS spreads are significantly positive following the ECB announcement (i) to additionally buy Spanish and Italian sovereign bonds and (ii) to support financial institutions by conducting an exceptional LTRO. This is remarkable since bond yields do not show significant effects on these dates, meaning that credit risk is not fully re- flected in bond yields. This observation will, however, not be discussed further in this paper and is subject for future research.

The analysis for the GIIPS countries in Table 6 presents a consistent and expected result for the first group of announcements related to the purchase of sovereign bonds: most of the CDS spread changes are significant and negative, indicating that investors expect a lower credit risk due to the rescue activities of the ECB. The second group of announcements, which is related to the support of bank lending, however, has a positive and to some extent even significant impact on the GIIPS countries’ CDS spreads. One potential argument for this fact is that investors expect large bail-outs and supporting activities in the banking sector to divert the ECB’s focus from rescuing the Eurozone countries to rescuing financial institutions.

To sum up this section, the specific event of the ECB announcing to purchase sovereign bonds has a significant and positive impact on nominal bond yields as well as on inflation swap rates, which strengthens evidence that investors’ inflation expectations are affected. Finally, the finding that this event does not have a significant and positive impact on French and German CDS spreads supports the

hypothesis that the event had an impact on investors’ inflation expectations and, consequently, influenced ECB’s credibility regarding its aim to maintain price stability.

4 Conclusion

In this paper, I examined the ECB’s credibility regarding its main task - the maintenance of price stability, i.e., inflation rates close to 2%, in the Eurozone.

Investors’ doubts regarding the ECB’s credibility might increase since one possi- bility to at least partially lower high debt burdens, which were amassed during the current crisis and even before, are rising inflation rates. Certainly, the ECB persistently confirms to maintain price stability with an inflation target close to 2% percent. In this paper, however, I analyze investors’ inflation expectations following specific ECB announcements. Based on the Fisher equation, nominal bond yields are investigated using an event study in order to analyze whether inflation expectations have changed or not. This analysis allows for inferences regarding the ECB’s credibility with respect to the maintenance of price stability.

The properties of an event study approach allow for a proper analysis since, the immediate effects (i.e., daily yield changes) of an ECB announcement on investors’ inflation expectations are investigated. In the case of Germany and France, the announcement concerning the purchase of government bonds is sta- tistically significant with a positive sign. This announcement has a significant impact for all maturities of German bonds and for nearly all maturities of French bonds. Bond yields increased on average by 14 and 7.5 basis points for Germany and France, respectively, indicating that investors do have concerns regarding this announcement and subsequently change their inflation expectations.

Two robustness checks with European inflation swap rates and sovereign CDS spreads to exclude the possibility of the effect being due to a change in credit risk instead of inflation expectations are conducted. The results strengthen the evidence in favor of the hypothesis of a change in inflation expectations for the specific event day mentioned above. The significant shift of inflation expectations based on sovereign bond yields and further confirmed by inflation swaps and CDS spreads suggests investors’ increasing mistrust regarding the ECB’s aim of price stability and a loss of its credibility at least on that specific announcement day.