Markets expect decade of below-target inflation even as ECB readies QE

Mon Jan 19, 2015 8:28am EST
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By Marius Zaharia

LONDON (Reuters) - Days before the European Central Bank is expected to deploy its ultimate monetary easing weapon, financial markets are showing no sign of confidence that it will push inflation anywhere near target in the next decade.

The ECB is expected to launch a program to print hundreds of billion of euros in new money by buying government bonds as soon as Thursday, with the explicit aim of boosting inflation. Yet market-implied inflation expectations have fallen relentlessly.

The major driver has been a nearly 60 percent drop in oil prices since June, hitting the cost of a wide range of goods and services and taking investors and policymakers by surprise.

What is striking, though, is that inflation expectations in the euro zone have fallen at a similar pace to that seen elsewhere, including the United States, where the Federal Reserve is expected to tighten monetary policy this year.

Market participants say that is because investors are beginning to doubt the power of quantitative easing as a policy tool. Some even question the ECB's credibility.

The euro five-year, five-year break even forward, a gauge of the market's longer-term inflation expectations, has fallen 60 basis points in the past six months and 20 bps this year alone.

The contract, which shows where markets expect 2025 inflation forecasts to be in 2020, trades at record lows around 1.50 percent, well below the ECB's roughly 2 percent goal. Its U.S. equivalent stands at 2.16 percent, down from 2.33 percent in December and 2.80-2.90 percent half a year ago.

It is expected to rise in Europe a bit once the ECB announces QE, but not by much.   Continued...

The European Central bank (ECB) headquarters are pictured in Frankfurt in this September 11, 2014 file photo. REUTERS/Ralph Orlowski/Files