How is expected inflation formed?

We look at expected inflation in financial markets in the United States and the euro zone, as measured by inflation swaps (5-year and 10-year). We seek to determine how these inflation expectations are formed: What is the reaction to inflationary shocks? If it is strong, the central banks probably have low credibility; What is the reaction to deflationary shocks? If it is weak, it is because financial market participants believe that expansionary monetary policies are effective at lifting inflation. We find: A weak reaction by expected inflation to positive inflation shocks, which means that the central banks have high credibility; A stronger, although still moderate, reaction by expected inflation to negative inflation shocks, which implies a belief in a certain degree of monetary policy effectiveness.