ECB Will Be Unphased By Shift In Market-Implied Inflation Expectations

Market-implied measures of inflation expectations in the euro area have lurched lower amid the growth-driven equity selloff. For the time being the ECB will look through this development given that the policy setting is underpinned by the in-house inflation criteria.

• The EUR5y5y forward inflation swap has traded down to 2.1675%, down from a 2024 high of 2.3925% in April and returning to levels not seen since mid-2022. Similarly, the 7-year German inflation breakeven rate has pushed down to 1.6931% from a YTD high of 2.1740%, with similar downside occurring in French and Italian breakevens.
• The ECB has referred to market-based inflation measures less often of late, particularly compared to the 2021-2022 inflation runup and certainly compared to Mario Draghi's tenure. This may reflect increasing confidence in the staff macroeconomic projections (which had come under intense scrutiny in 2021-2022) and lower energy prices (which were previously fuelling spot and expected inflation).
• Most important, however, is the ECB's own determination of the inflation outlook which guides policy.
• It is repeatedly asserted that interest rate decisions are based on an "assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation and the strength of monetary policy transmission. "
• More recently the ECB has gone further and stressed the interrelationship of wages, profits and productivity as a key determinant of inflation and in turn the direction of policy rates.
• Having invested considerable intellectual capital in justifying the determination of the policy rate setting, even a significant drawdown in market-based inflation expectations would not prompt a faster rate cutting cycle.