Falling inflation expectations increase pressure on ECB

Financial market measures of inflation expectations have fallen to levels at which the ECB has loosened policy in the past. Indeed, the ECB’s favoured measure of expectations – the five-year/five-year inflation swap rate – is at its lowest level since late 2016. Admittedly, at April’s press conference Mr Draghi argued that the decline in the inflation swap rate was due to a reduction in the perceived probability that inflation overshoots the target, rather than a reduction in the mean expectation of inflation. But since that meeting, the rate has fallen even further. We think that the Bank will respond at tomorrow’s press conference by strengthening its forward guidance on interest rates and announcing generous terms to the new TLTROs, which begin in September. But this is unlikely to be enough to push up inflation expectations significantly. So we still think that the Bank will eventually have to re-launch QE, probably next year.