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Capital Markets
Lower inflation expected as oil drops
From the Financial Times of Mon, 15 Dec 2014 20:05:09 GMT

Expectations priced into financial markets about future inflation rates have hit fresh lows on both sides of the Atlantic as the repercussions of tumbling oil costs spread.

A gauge of long-term inflation expectations watched closely by the European Central Bank fell on Monday to its lowest since comparable data started a decade ago. The fall followed a sharp decline last week in a similar measure watched by the US Federal Reserve.

The shift adds to the pressure on monetary policy makers, with markets implying inflation will fall short of central banks’ inflation targets for protracted periods. It also underscores the extent of the re-pricing across markets triggered by recent sharp oil price falls.

“The longer we have pain in commodity markets and spillovers into emerging markets, the more we will see people giving up on the idea that there is going to be inflation in developed economies,” said Alessandro Tentori, head of rates strategy at Citigroup.

At the heights of the post-2007 financial crises, when deflation fears erupted briefly, US and eurozone inflation expectations also dropped sharply. But eurozone inflation expectations have recently fallen below even levels reached then.

The ECB’s chosen expectations gauge, based on swaps prices, on Monday implied an average inflation rate over five years starting in five years of just 1.68 per cent. A five-year forward measure based on Fed methodology has also fallen below 2 per cent to test the lows seen in 2008. Usually, such gauges trade significantly higher than the 2 per cent threshold.

Expectations have been driven lower by exceptionally weak actual inflation readings — annual eurozone hit a five-year low of just 0.3 per cent in November and is expected to decline further in the months ahead. But markets were also gloomy about global economic prospects, said Gilles Moec, European economist at Bank of America Merrill Lynch. “Even in the US, there is sensitivity to the global level of slack in economies. It is not enough to be growing fast if the rest of the world is not doing the same.”

While central banks will usually look through a decline in crude prices and economists have touted the benefits to economic growth, ultra-low inflation in the eurozone has raised the threat of the ECB seriously undershooting its target of an annual rate below but close to 2 per cent. ECB officials fear increasingly weak eurozone inflation reflects not just sharply lower oil prices but weak demand pressures.

Mario Draghi, ECB president, drew attention to the five-year inflation swap-rate in August, when he suggested its fall then supported the case for more action by monetary policy makers. Expectations are mounting that he will launch full-blown “quantitative easing”, or large scale government bond purchases, early in 2015.

“If the drop in inflation expectations was temporary and the result of an exogenous shock, central banks would tend to disregard it,” said Mr Tentori. “The problem is that it is not like 2008 or 2009, and the market is not buying into the story that it is just because of oil prices. They seem to think there is more behind it.”

Additional reporting by Vivianne Rodrigues in New York



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