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FOCUS | EUROZONE – Inflation Expectations Summary

Core Content

This document analyzes the current state of EUR inflation expectations and the factors influencing their trajectory, focusing on the potential for structural entrenchment and the role of monetary policy, global growth, and the Phillips curve.

Key Messages

• The decline in EUR breakeven inflation is not yet structurally entrenched, suggesting a possibility of a rebound if the ECB delivers a convincing stimulus package in September.
• Negative inflation risk premia are dragging on investor base-case inflation expectations, indicating a high risk of structural entrenchment if the ECB disappoints.
• The document outlines a three-step framework for tracking entrenchment risk:
  1. Accumulation of risk: A negative shock reduces investor confidence and increases downside risk premia.
  2. Downward shift: Prolonged downside risk premia lead to a gradual decline in base-case inflation expectations.
  3. Structural entrenchment: If low inflation persists, the market may start to price out the possibility of upside surprises, making low expectations entrenched.
• EUR inflation expectations are currently in Stage 2 of this cycle, with base-case expectations starting to shift downward but not yet fully entrenched.

Factors Driving Inflation Risk Premia

The decline in EUR inflation risk premia is influenced by:

• Monetary policy: The ECB's potential stimulus measures are a key driver.
• Global recession risk: Weak global growth and the risk of a downturn are pressing concerns.
• Declining confidence in the Phillips curve: The lack of response from core inflation to wage growth suggests a weakening link between cost pressures and inflation.

Inflation Expectations and the Real Economy

• Market-based inflation expectations are important for the real economy, as they influence bond yields and financial conditions.
• A decline in inflation expectations typically leads to falling real rates, as markets price in future policy easing.
• If expectations decline without corresponding macroeconomic improvement, financial conditions may tighten, leading to higher real yields and reduced risk appetite, which could negatively impact the real economy.

Inflation Options as a Gauge

• Inflation options data can help assess the expectations cycle by analyzing implied volatility across different strike prices.
• The mode of the distribution represents base-case expectations, while the skew reflects inflation risk premia.
• The market is still reacting to ECB policy events, indicating that monetary policy remains a key influence on inflation expectations.

Inflation Forecasts

(f) – BNP Paribas forecasts

• The Easter effect caused significant volatility in core inflation data in early 2019, but it is expected to fade by June.
• Core inflation is expected to edge higher towards the end of 2019, reaching 1.3% y/y, which would be the highest since early 2013.
• Structural headwinds suggest that cost-push pressures will have a weaker pass-through to prices compared to previous cycles.

Additional Insights

• Global growth indicators such as the trade-weighted dollar and world trade growth are expected to influence inflation risk premia in the coming months.
• The "super" core inflation index continues to trend upward, indicating that core inflation is still firming despite weak GDP growth.
• The ECB's symmetric inflation target is expected to increase the pressure on the central bank to respond to inflation expectations, potentially leading to a resumption of quantitative easing.

Risk Assessment

• Downside risks to inflation are currently significantly higher than upside risks, with a potential for Japanese-style deflation if the economy slips into a recession before core inflation breaks from its recent trend.
• The ECB's policy decisions are expected to play a crucial role in determining whether the current downward trend in inflation expectations is reversible or structural.

Conclusion

The EUR inflation expectations are currently in a downward shift phase, with the potential for a structural entrenchment if the ECB fails to deliver effective stimulus. However, the ECB's actions in September, along with global growth data and the Phillips curve dynamics, could influence the trajectory of inflation expectations. The document highlights the importance of monitoring these factors closely and suggests that OATEi real yield curve flatteners are a preferred trade in this environment.