Inflation expectations ease on expected new phase for ECB

Most measures of inflation expectations eased in recent months, with the notable exceptions not as bad as they look. This improvement alleviates concerns about possible second-round effects or an unanchoring of inflation expectations, making it easier for the European Central Bank to bring actual inflation back to its 2% target. This will also facilitate a gradual return from the ECB to a more traditional reaction function after a period where taming high inflation was the sole focus.

What you will learn:

• This gradual return to normality will result in rate cuts next year, in our view. In the near term, the dovish tilt from the inflation expectations data supports our updated call that the ECB will stay put in September, though the decision remains close to a coin toss.
• Looking at the data, surveys of households and firms have been encouraging, but other measures are more mixed. For one, inflation swap rates have risen in recent months to multi-year highs. However, we find that inflation risk premia, rather than inflation expectations, drove this increase. This is important because, while the ECB would likely try to address a spike in expectations, there is little it can do about an upward move in risk premia, particularly ex-ante.
• The second source of disappointment comes from some stickiness in two gauges of probability of high medium-term inflation. We continue to think that the significance of the survey of professional forecasters’ high-inflation cluster has been exaggerated. As for investors, while our analysis shows that concerns about high inflation have not gone away, deflation risk is also back on their radar. As of now, both extremes have higher-than-usual, but similar, probabilities.