Investors’ expectations of eurozone inflation hit 13-year high

A closely watched gauge of long-term inflation expectations in the eurozone has reached its highest level since 2010, in a sign that some investors think the European Central Bank will struggle to bring inflation back to its 2 per cent target.

The so-called five-year, five-year forward inflation swap — a measure of markets’ assessment of price growth over the second half of the next decade — hit 2.66 per cent this week, despite signs that the current burst of inflation has peaked as tighter monetary policy takes effect.

Inflation expectations have edged higher in most big economies in recent weeks, driven partly by climbing oil prices. But the rise is particularly notable in the eurozone, where inflation was persistently below the ECB’s target in the decade after the 2008 financial crisis, leading to widespread predictions that the region was headed for a Japan-style deflationary slump. 

“The Japanification of Europe is likely to be a thing of the past,” said Florian Ielpo, head of macro at Lombard Odier. “This will be a sharp contrast to the previous decade.”

Lombard Odier estimates the eurozone’s inflation could be as much as 1.5 percentage points on average higher in the decade to 2032 than it was in the previous 10 years, as rising energy and goods prices, exacerbated by Russia’s invasion of Ukraine, feed through to wage demands.

The increase in long-term inflation expectations could be uncomfortable for the ECB, which has hinted that it is close to the end of its tightening cycle after delivering nine consecutive interest rate rises, lifting its deposit rate to a 22-year high of 3.75 per cent last month.

The central bank has already had some success curbing price pressures. Headline inflation was 5.3 per cent in July, down from a peak of 10.6 per cent last October. Core inflation flatlined at 5.5 per cent last month, even as services inflation, partly fuelled by higher wages, rose to a record high of 5.6 per cent.

Investors are evenly split on whether the ECB will deliver one more rate increase later this year.

“At some point you would expect the five-year, five-year to plateau — the fact it has been rising steadily in the past six months makes me wonder if markets are concerned that we are not out of the inflationary spiral,” said Tomasz Wieladek, chief European economist at T Rowe Price.

He added that the eurozone in particular is at risk of stagflation, a scenario where activity deteriorates but prices keep rising rapidly, in part owing to powerful collective wage bargaining agreements in big economies which increase the risk of a self-reinforcing upward spiral between prices and pay.

Large fiscal packages launched in response to the Covid-19 pandemic, as well as to tackle last year’s energy crisis and to boost military budgets following Russia’s invasion of Ukraine, have supported demand and contributed to price growth — even if some are now being wound down.

“I think the structural deflationary forces that pulled down headline inflation in the post-crisis era have faded — partly because balance sheets are stronger, but also because of pandemic-related fiscal support,” said Neil Shearing, chief economist at Capital Economics.

However Shearing, in keeping with most economists, believes the ECB will succeed in bringing inflation back to its 2 per cent target, even if it takes a couple of years, “albeit with overshoots more likely than undershoots over the next decade”.

The five-year, five-year swap rate is designed to strip out the current economic cycle and show where the market thinks inflation will settle in the longer term. However, in practice it often moves in tandem with the short-term price pressures and has been buoyed by a recent rise in energy prices. It can also be skewed by a rise in hedging activity.

Former ECB president Mario Draghi drew particular attention to the measure by citing its fall below 2 per cent in a 2014 speech at the Federal Reserve’s annual Jackson Hole conference that laid the groundwork for the start of quantitative easing in Europe a few months later.

However, since Draghi’s departure in 2019, the ECB has appeared to give the measure less prominence. Its chief economist Philip Lane prefers to highlight “market-based indicators of inflation compensation”, which include several other elements, including inflation-linked bonds.

The ECB believes that after stripping out the “risk premium” element of long-term market measures of inflation — based on investors’ hedging activity — the remaining expectations component would be close to its 2 per cent target. Staff at the central bank cross-check this against its survey of professional forecasters, which last month found they expected eurozone inflation of 2.1 per cent in the long term.

Even so, investors’ bets on future inflation are a far cry from the pre-pandemic world when expectations languished well below the ECB’s target despite successive waves of stimulus. Core inflation — excluding energy and food prices — in the eurozone averaged 1 per cent between January 2013 and December 2019, driven in part by the looseness of the labour market.

“Now the backdrop is quite different,” said Ryan Djajasaputra, an economist at Investec. “Unemployment is at a record low, participation is at a record high, employment growth remains solid and wage growth has strengthened from what were subdued levels pre-pandemic.”

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