Investors are increasingly concerned that the European Central Bank (ECB) may inadvertently push inflation below its 2% target due to a slower-than-expected pace of interest rate cuts. This rising apprehension is reflected in the swaps market, where investors hedge against inflation risks. According to data compiled by Danske Bank for Reuters, market sentiment indicates that inflation could fall durably below the ECB’s target starting in January, much earlier than the ECB's own forecasts.
The ECB currently projects inflation—hovering at 2.2%—to reach its target of 2% by late 2025. This timeline contrasts sharply with market expectations, which foresee inflation dipping below target sooner than the central bank anticipates. As the ECB battles to rein in inflation, which was previously in double digits less than two years ago, the bank has initiated an easing cycle, commencing with its last interest rate cut earlier this month.
"The market is signalling to the ECB that they could be behind the curve," said Analissa Piazza, a fixed income research analyst at MFS Investment Management, which manages $639 billion in assets. She noted that if the ECB maintains its current trajectory of quarterly moves, it may risk allowing inflation to remain below the target for too long, complicating future efforts to boost it back up.
Recent data indicating an unexpected contraction in euro zone business activity for September has reinforced market skepticism regarding the ECB's optimistic inflation outlook. This has led traders to assign a greater than 50% probability to an interest rate cut in October, even as ECB policymakers have yet to signal such a move.
This rising sentiment about below-target inflation is not isolated to Europe. A Bank of America (BofA) investor survey conducted on September 13 revealed that while investors had initially predicted inflation would remain between 2%-3% in the U.S. and the euro zone by the end of 2025, the proportion of those expecting inflation to fall below target has grown in both regions.
In Sweden, the Riksbank is facing similar pressures, with inflation having dropped below target for three consecutive months, prompting the central bank to consider faster cuts. As markets react to these developments, the implications of inflation falling below target have raised alarm bells globally, highlighting the interconnectedness of economic conditions across different regions.
The Role of Oil Prices and Economic Growth
One of the key factors contributing to the inflationary pressures is the recent decline in oil prices. Earlier in September, oil prices fell to their lowest levels in nearly three years, dipping below $69 per barrel. Currently hovering around $74, these prices remain more than 6% lower than the cutoff date for the ECB's latest economic projections. This drop in oil prices could further impact the inflation outlook as the ECB navigates its monetary policy decisions.
While the swaps market does not predict the kind of ultra-low inflation that plagued the economy before the COVID-19 pandemic, it does indicate average inflation expectations of about 1.7% over the coming year. A significant market gauge of longer-term inflation expectations has also dropped to a two-year low, albeit remaining slightly above the 2% mark.
However, the divergence in inflation expectations signals a growing disconnect between market sentiment and the ECB's growth outlook. "The market is thinking the ECB is a little bit optimistic on growth," stated Guy Stear, head of developed markets strategy at Amundi Investment Institute. He projects euro zone growth to improve to 1% next year, up from 0.8% in 2023, but this is still less than half of the ECB's forecast of 1.3%.
Demand and Consumption Patterns
The ECB has acknowledged that domestic demand may be weaker than previously expected. The central bank is counting on goods disinflation to have run its course and is banking on rising real incomes to bolster consumption and drive economic growth. However, euro zone households are saving more than they did before the pandemic, and many economists argue that these savings are unlikely to be tapped into, given the current climate of weak consumer confidence.
Notably, economists from Nomura have observed that savers are opting to increase their asset holdings rather than accumulate more cash, further diminishing the likelihood of spending. Additionally, while wage growth has been volatile, it has decelerated more sharply than the ECB had anticipated, raising concerns about the potential for continued high services inflation.
Recent business activity data revealed that German companies are shedding jobs at the fastest pace outside of the pandemic in over 15 years. This trend serves as a cautionary signal, leading economists to re-evaluate the ECB's growth and inflation expectations. A more pessimistic economic outlook than the ECB currently envisions could bolster euro zone government bonds, which have underperformed compared to U.S. Treasuries this year.
Indeed, the rate-sensitive German two-year bond yields experienced their most significant daily decline in nearly two months following the latest business activity data. "The question simply remains given the weakness in overall growth... just how long can the ECB hold onto the idea that services inflation is sticky and we have to be patient?" queried Rohan Khanna, head of euro rates strategy at Barclays. He warned that the longer the ECB maintains this position, the more it risks worsening the economic situation, ultimately compelling it into deeper or potentially larger cuts down the line.
A Global Perspective on Inflation Risks
As the ECB grapples with its policy decisions, the global landscape presents a tapestry of inflationary challenges. The concern about below-target inflation is becoming increasingly prevalent among investors worldwide, as they grapple with the aftershocks of the COVID-19 pandemic, supply chain disruptions, and changing consumer behavior.
In the United States, the Federal Reserve has also been closely monitoring inflation dynamics, with recent BofA surveys suggesting that investor confidence in inflation exceeding 2% has waned. Many are beginning to position themselves for a future where inflation could remain stubbornly low, particularly if economic growth continues to disappoint.
The interconnected nature of global markets means that shifts in one region's inflation dynamics can reverberate across borders. For instance, if European inflation were to trend below target, it could dampen demand for exports from the U.S. and other economies, potentially leading to a cascade of reduced growth expectations globally.
As investors recalibrate their expectations regarding inflation in both the euro zone and the United States, the implications for monetary policy become increasingly complex. The ECB faces the dual challenge of managing inflation while ensuring economic growth does not falter. With market indicators suggesting a rising risk of below-target inflation, the central bank must navigate a delicate balancing act in the months ahead.
In a climate where economic data continues to reveal troubling trends, the specter of persistent low inflation looms larger. For the ECB and central banks worldwide, the next steps will be critical as they respond to shifting market dynamics and investor sentiments. As these institutions consider their future policy trajectories, the global economic landscape will undoubtedly remain in flux, necessitating vigilance and adaptability in the face of evolving challenges.
(Source:www.reuters.com)
The ECB currently projects inflation—hovering at 2.2%—to reach its target of 2% by late 2025. This timeline contrasts sharply with market expectations, which foresee inflation dipping below target sooner than the central bank anticipates. As the ECB battles to rein in inflation, which was previously in double digits less than two years ago, the bank has initiated an easing cycle, commencing with its last interest rate cut earlier this month.
"The market is signalling to the ECB that they could be behind the curve," said Analissa Piazza, a fixed income research analyst at MFS Investment Management, which manages $639 billion in assets. She noted that if the ECB maintains its current trajectory of quarterly moves, it may risk allowing inflation to remain below the target for too long, complicating future efforts to boost it back up.
Recent data indicating an unexpected contraction in euro zone business activity for September has reinforced market skepticism regarding the ECB's optimistic inflation outlook. This has led traders to assign a greater than 50% probability to an interest rate cut in October, even as ECB policymakers have yet to signal such a move.
This rising sentiment about below-target inflation is not isolated to Europe. A Bank of America (BofA) investor survey conducted on September 13 revealed that while investors had initially predicted inflation would remain between 2%-3% in the U.S. and the euro zone by the end of 2025, the proportion of those expecting inflation to fall below target has grown in both regions.
In Sweden, the Riksbank is facing similar pressures, with inflation having dropped below target for three consecutive months, prompting the central bank to consider faster cuts. As markets react to these developments, the implications of inflation falling below target have raised alarm bells globally, highlighting the interconnectedness of economic conditions across different regions.
The Role of Oil Prices and Economic Growth
One of the key factors contributing to the inflationary pressures is the recent decline in oil prices. Earlier in September, oil prices fell to their lowest levels in nearly three years, dipping below $69 per barrel. Currently hovering around $74, these prices remain more than 6% lower than the cutoff date for the ECB's latest economic projections. This drop in oil prices could further impact the inflation outlook as the ECB navigates its monetary policy decisions.
While the swaps market does not predict the kind of ultra-low inflation that plagued the economy before the COVID-19 pandemic, it does indicate average inflation expectations of about 1.7% over the coming year. A significant market gauge of longer-term inflation expectations has also dropped to a two-year low, albeit remaining slightly above the 2% mark.
However, the divergence in inflation expectations signals a growing disconnect between market sentiment and the ECB's growth outlook. "The market is thinking the ECB is a little bit optimistic on growth," stated Guy Stear, head of developed markets strategy at Amundi Investment Institute. He projects euro zone growth to improve to 1% next year, up from 0.8% in 2023, but this is still less than half of the ECB's forecast of 1.3%.
Demand and Consumption Patterns
The ECB has acknowledged that domestic demand may be weaker than previously expected. The central bank is counting on goods disinflation to have run its course and is banking on rising real incomes to bolster consumption and drive economic growth. However, euro zone households are saving more than they did before the pandemic, and many economists argue that these savings are unlikely to be tapped into, given the current climate of weak consumer confidence.
Notably, economists from Nomura have observed that savers are opting to increase their asset holdings rather than accumulate more cash, further diminishing the likelihood of spending. Additionally, while wage growth has been volatile, it has decelerated more sharply than the ECB had anticipated, raising concerns about the potential for continued high services inflation.
Recent business activity data revealed that German companies are shedding jobs at the fastest pace outside of the pandemic in over 15 years. This trend serves as a cautionary signal, leading economists to re-evaluate the ECB's growth and inflation expectations. A more pessimistic economic outlook than the ECB currently envisions could bolster euro zone government bonds, which have underperformed compared to U.S. Treasuries this year.
Indeed, the rate-sensitive German two-year bond yields experienced their most significant daily decline in nearly two months following the latest business activity data. "The question simply remains given the weakness in overall growth... just how long can the ECB hold onto the idea that services inflation is sticky and we have to be patient?" queried Rohan Khanna, head of euro rates strategy at Barclays. He warned that the longer the ECB maintains this position, the more it risks worsening the economic situation, ultimately compelling it into deeper or potentially larger cuts down the line.
A Global Perspective on Inflation Risks
As the ECB grapples with its policy decisions, the global landscape presents a tapestry of inflationary challenges. The concern about below-target inflation is becoming increasingly prevalent among investors worldwide, as they grapple with the aftershocks of the COVID-19 pandemic, supply chain disruptions, and changing consumer behavior.
In the United States, the Federal Reserve has also been closely monitoring inflation dynamics, with recent BofA surveys suggesting that investor confidence in inflation exceeding 2% has waned. Many are beginning to position themselves for a future where inflation could remain stubbornly low, particularly if economic growth continues to disappoint.
The interconnected nature of global markets means that shifts in one region's inflation dynamics can reverberate across borders. For instance, if European inflation were to trend below target, it could dampen demand for exports from the U.S. and other economies, potentially leading to a cascade of reduced growth expectations globally.
As investors recalibrate their expectations regarding inflation in both the euro zone and the United States, the implications for monetary policy become increasingly complex. The ECB faces the dual challenge of managing inflation while ensuring economic growth does not falter. With market indicators suggesting a rising risk of below-target inflation, the central bank must navigate a delicate balancing act in the months ahead.
In a climate where economic data continues to reveal troubling trends, the specter of persistent low inflation looms larger. For the ECB and central banks worldwide, the next steps will be critical as they respond to shifting market dynamics and investor sentiments. As these institutions consider their future policy trajectories, the global economic landscape will undoubtedly remain in flux, necessitating vigilance and adaptability in the face of evolving challenges.
(Source:www.reuters.com)