Markets fear ECB's cautious path risks tipping inflation below target

If traders are right, the European Central Bank is now at risk of pushing inflation below its 2 per cent target by cutting interest rates too slowly, hurting the bloc's fragile economy.

The swaps market, where investors hedge inflation risk by exchanging payments tied to the rate of price growth, suggests inflation will fall durably below the ECB's target from January, according to data compiled by Danske Bank for Reuters on Wednesday.

That's much earlier than the ECB, which expects inflation - currently at 2.2 per cent and potentially dipping below target this month before rising back - to fall to 2 per cent in late 2025.

The ECB has been battling to rein in inflation, which was running in double digits less than two years ago. But price pressures have eased following aggressive rate hikes, prompting the bank to kick off an easing cycle in June. It last cut rates earlier this month.

"The market is signalling to the ECB that they could be behind the curve," said Analissa Piazza, fixed income research analyst at MFS Investment Management, which manages $639 billion.

If the bank continues quarterly moves through next year - slower than markets expect - it could push inflation below target for too long and then struggle to push it back up in the future, she added.

Data this week showing euro zone business activity unexpectedly contracted in September vindicated markets, which have expected swifter disinflation than the ECB for a while.

Traders now see more than a 50 per cent chance of an October rate cut, which policymakers had reckoned was unlikely following this month's meeting.

Reuters reported on Thursday that dovish policymakers are preparing to fight for an October rate cut, a move likely to meet resistance from their conservative peers.

Investors reckon the risk of below-target inflation is rising globally.

While they saw inflation between 2 per cent-3 per cent as the more likely outcome in the United States and the euro zone at end-2025, the share of investors who expect below target inflation rose in both regions this month, a BofA investor survey showed on Sept. 13, just before the Federal Reserve's 50 basis-point rate cut.

In Sweden, inflation has been below target for three straight months, prompting the Riksbank to put faster cuts on the cards on Wednesday.

A key part of the discrepancy is oil prices, which dropped to their lowest in nearly three years below $69 earlier in September.

At around $72 on Thursday, they were still more than 9 per cent lower than at the Aug. 16 cut-off date for the ECB's latest economic projections.

For sure, markets aren't signalling the kind of ultra-low inflation that prevailed before the COVID-19 pandemic that the ECB struggled to reignite, prompting it to unleash vast bond purchases and a controversial experiment with negative interest rates.

The swaps point to average inflation of 1.7 per cent over the next year.

And a key market gauge of longer-term inflation expectations , which dropped to a two-year low earlier in September, remains just a touch above 2 per cent.

But crucially, market inflation expectations signal disagreement with the ECB's outlook on growth.

"The market is thinking the ECB is a little bit optimistic on growth," said Amundi Investment Institute's head of developed markets strategy Guy Stear, who expects euro zone growth to improve to 1 per cent next year from 0.8 per cent this year, less than half the rise to 1.3 per cent the ECB expects.

While acknowledging domestic demand will be weaker than previously expected, the ECB reckons goods disinflation has run its course and expects rising real incomes to support consumption and drive growth.

But euro zone households are saving more than they did before the pandemic and some economists reckon they are unlikely to run down those savings and boost consumption as consumer confidence remains weak.

Nomura economists note that, rather than accumulating more cash, savers have upped their asset holdings, making them less likely to spend.

And while volatile, wage growth - which ECB hawks in particular worry risks keeping services inflation high - has slowed more sharply than the bank expected.

Monday's business activity data, showing German businesses shedding staff at the fastest pace in over 15 years outside of the pandemic, also warranted caution, economists said.

A bleaker economic outlook than the ECB expects would support euro zone government bonds, which have underperformed U.S. Treasuries this year, investors said.

Indeed, rate-sensitive German two-year bond yields registered their biggest daily fall in nearly two months on Monday.

"The question simply remains given the weakness in overall growth... just how long can the ECB hold onto the idea that services inflation is sticky and we have to be patient?" said Barclays's head of euro rates strategy Rohan Khanna.

“The longer they hold onto that argument, it worsens the economic situation and will hence force them into deeper cuts, or potentially even bigger cuts down the line.”