Market Questions ECB's Ability To Deliver 2% Inflation

In response to the rapid decline in euro inflation over the past year, bond markets are now starting to question the ECB’s ability to deliver 2% inflation any time soon. The 10-year euro inflation swap is now priced at 1.77%, implying that the market is now looking for inflation to average 1.25-1.50% over the next 10 years (assuming a normal ‘inflation risk premium’ of 0.25-0.50%.

This is an additional factor putting pressure on the ECB to ease policy further. A prolonged period of inflation expectations at this level is a clear challenge to the ECB’s credibility and if it stays at this level for a long time without the ECB acting, it would indirectly mean the ECB would tolerate that markets doubt its commitment or ability to deliver 2% inflation. The ECB is also watching inflation expectations from its own Survey of Professional forecasters closely and, so far, the long-term inflation expectation in this survey is still anchored just below 2%. However, the risk for the ECB is that this expectation will become lower if inflation stays very low for a longer period without the ECB reacting. As we believe inflation will remain below 1% for a prolonged period, we expect the ECB to respond by easing again, even as the economy recovers further – see Flash Comment: Euro area inflation is still low – our forecast is below ECB’s projection, 16 January

The current level of the 10-year inflation swap is close to the previous lows seen in 2008, 2010 and 2012. However, on those occasions, the inflation swap subsequently rose again within three to six months. This suggests there could be an interesting opportunity to hedge inflation at low levels for investors with a long-term real purchasing power commitment to clients. It may also be a trade idea for tactical investors who believe there could be a move higher over the next year.

First, the market is not pricing inflation to revert to 2% until 2021-22. Although we agree with the market that inflation in the next two years will be low, in our view the market is too low further out on the inflation curve. Second, the main driver for the sharp decline in inflation is lower commodity prices. However, history suggests these prices are highly unpredictable. While food prices are low now, this could change if supply goes down next year in response to lower prices or the weather changes adversely as seen in 2008 and 2011. Finally, inflation swaps tend to go higher when central banks respond to the lower expectations defending their credibility. For example, every time the Fed did QE inflation expectations rose in the US.

The timing is uncertain, of course, as a further decline in inflation in coming months could push inflation swap rates even lower. However, we believe we are entering a window where it is worth considering hedging long-term inflation.

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