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FOCUS | EUROZONE – Inflation Expectations Summary

Core Content

This document analyzes the current state of EUR inflation expectations and their potential evolution, focusing on the interplay between monetary policy, macroeconomic factors, and market dynamics. It outlines a three-step framework to assess the risk of structural entrenchment in inflation expectations and highlights the ECB's role in shaping these expectations.

Key Messages

• The decline in EUR breakeven inflation this year is not yet structurally entrenched, but there is a risk that it could become so if the ECB fails to deliver a convincing policy package.
• A negative inflation risk premium is dragging on investor base-case inflation expectations.
• The three-step framework for tracking inflation expectations is:
  1. Accumulation of risk: A negative shock weighs on investor confidence, leading to an accumulation of downside risk premia.
  2. Downward shift: If the risk premium persists, it will gradually lower base-case inflation expectations.
  3. Structural entrenchment: Prolonged low inflation can lead to a structural decline in expectations, where the market prices out the possibility of upside surprises.

Drivers of Inflation Expectations

• Monetary policy: The ECB's potential policy changes, especially a resumption of QE, are expected to influence inflation expectations.
• Global growth concerns: A weak global growth outlook increases the risk of recession and reduces inflationary pressures.
• Phillips curve dynamics: The unresponsiveness of core inflation to wage growth suggests a weakening of the traditional inflation mechanism, but "super" core inflation remains on an upward trend.

Market Reaction and Policy Outlook

• The market is still reacting to ECB policy-related events, indicating that inflation expectations are not yet fully entrenched.
• If the ECB delivers a strong policy response, inflation expectations could rebound.
• However, if expectations become entrenched, additional policy stimulus may have limited impact.

Inflation Expectations Forecast

(f) BNP Paribas forecasts

Inflation Expectations and Real Yields

• A decline in inflation expectations is typically followed by falling real rates as markets price in future policy easing.
• If expectations become entrenched and policy stimulus is not effective, real yields may rise, inflation expectations could fall further, and risk appetite may collapse.

Inflation Options and Risk Premia

• Inflation options can be used to gauge the expectations cycle by comparing implied volatility across strike prices.
• The "mode" of the distribution represents base-case expectations, while the "skew" reflects the risk premium.
• The inflation options market is not highly liquid, and the methodology assumes a risk-neutral market.

Global Growth and Recession Risk

• Weak global growth increases the risk of recession and dampens inflationary pressures.
• The global PMI has shown a strong correlation with EUR inflation risk premia since 2015.
• There may be some improvement in Q4 if global growth indicators stabilize.

Phillips Curve and Core Inflation

• The Phillips curve's slope is becoming less responsive, with firms absorbing cost increases into profit margins.
• Despite weak GDP growth, "super" core inflation continues to rise, suggesting a potential upward surprise in core inflation.
• Traditional core HICP has also shown some firming, averaging slightly better than expected.

Conclusion

• EUR inflation expectations are currently in the second stage of the cycle, with base-case expectations shifting lower but not yet structurally entrenched.
• The ECB's policy response in September is critical in determining whether this trend reverses or continues.
• The document highlights the importance of monitoring both risk premia and base-case expectations to assess the broader inflation outlook.