Inflation expectations still below 2% target set by ECB

The ECB recently announced that it will be pumping €60 billion in to the economy every month by buying assets, mainly sovereign bonds. This is in a bid to revive inflation and growth in the Eurozone. Due to this deflationary spiral, consumers have stopped spending in anticipation of declining prices and under this new programme by the ECB, they will bear 20% of the risk. The other 80% will be borne by the national central banks. This new programme will commence in March and will end in September 2016.

Germany has opposed this idea on a number of occasions as it does not want other countries in the Eurozone to use this as an excuse to put off structural reforms. Mario Draghi had also been conveying this point last year before programme talks started. Structural reforms are needed for QE to work otherwise the Eurozone may fall into a liquidity trap.

The ECB’s preferred measure of inflation expectations is the 5y5y forward swap rate. This provides an indication of medium-term inflation since interest rates are closely linked to inflation. The swap rate has been declining, indicating that the receivers are demanding a lower fixed rate in 5 years’ time. A lower fixed rate indicates that the market expects inflation to be lower in the future. However, as is shown from the graph below, there has been a sharp increase in the swap rate. The reason behind this is that market participants believe that this new programme will be successful. However, as can be seen from the chart, market participants think that inflation will be lower than 2% target in the medium-term.

The ECB should be wary of Japan-style liquidity trap. This new programme may not work and may result in more pumping of money into the economy which may become routine. On another note, the CPI Flash Estimate y/y is expected to be on forecast (-0.5%) due to decline in oil prices and weak demand in the Eurozone.

The Pound gained against the Euro which could affect the UK export market. The Eurozone is the UK’s largest trading partner and a decline in the demand for UK goods by Eurozone consumers will result in lower economic growth and inflation for the UK. Declining oil prices and the weak Eurozone have therefore pushed back expectations that the Bank of England will raise interest rates in the near future. There has also been increased uncertainty due to the UK General Election which is in May. If the Conservatives are given another term, then an EU referendum is likely to take place. This may result in the UK leaving the European Union which would be devastating for the UK economy. 

We expect Prelim GDP q/q to be on forecast (0.6%) i.e. 0.1% below the previous figure. The primary reason behind this is because of the weak demand from the Eurozone.