The ECB recently published the results of its second Survey on the Access to Finance of Enterprises. All those expecting a huge increase in inflation expectations among Eurozone consumers. As of April, that expected inflation rate over the next year has climbed all the way to 3.1%. This is an improvement from the prior 2.9%, a 0.2 percentage point increase. Further increases would indicate the beginning of serious concerns about inflationary pressures building in the Eurozone economy.
The survey results indicate that consumers are anticipating inflation to keep moving higher in the short-term. The ECB is fundamental to how monetary policy operates across the Eurozone. It tries to control inflation, targeting a long-run rate of 2 percent. Keeping track of these expectations is extremely important as they can shape economic behavior like consumption and investment.
Yet given the long-term effects of the pandemic, this survey indicates a continuing short-term optimism. Inflation expectations three years out are anchored at 2.5%, and five-year expectations are still anchored at 2.1%. These slightly longer-term projections imply some short-term stability in consumer confidence about the overall direction of the economy.
Understanding Eurozone Inflation Measurements
Eurozone inflation is usually represented as a YoY percentage change, calculated on an MoM and YoY basis. This two-prong approach makes it possible to get a complete picture of the impact on prices in both the short- and long-term. The ECB closely monitors these metrics to assess the state of the euro area economy and guide its monetary policy actions.
Core inflation has been a core metric for central banks. It removes fluctuating factors such as food and energy costs, providing a more accurate picture of the underlying trends in inflation. At the end of the day, what makes core inflation so important to economists is that it directly informs monetary policy decisions like interest rate hikes. When core Consumer Price Index (CPI) inflation rises above the target of 2%, it usually results in interest rate hikes. If core CPI drops below this level, it usually leads to interest rate cuts.
The ECB’s vigilance over these indicators is a cornerstone of economic stability in the Eurozone that cannot be discounted. Through maintaining inflation at a controllable level the ECB hopes to create an environment which is more favorable to growth and overall stability.
Implications of Rising Inflation Expectations
The implications of this recent rise in inflation expectations are significant for consumers and policymakers alike. And with inflation expectations now pegged at 3.1% for the coming year, consumers may change their spending behavior, expecting to pay more in the future. This change requires a dramatic increase in demand. Consumers are motivated to buy now while prices are still affordable.
For central banks, increased inflation expectations make future monetary policy moves even harder. If inflation consistently exceeds target levels, the ECB may be compelled to raise interest rates to curb spending and stabilize prices. Lastly, raising interest rates will slow the economy, since higher borrowing costs will affect both businesses and consumers.
There is little doubt that currency traders are focusing heavily on these developments as the current EUR/USD exchange rate, which has been trading around 1.1325, reflects. If inflation expectations are stable or rising, such signals lead to sharp appreciation of the exchange rates. Today, markets spike or tank depending on who believes bond-buyers will soon increase interest rates.
Consumer Sentiment and Economic Outlook
Especially in the short run, consumer sentiment is an important driver of economic outcomes. According to the results of the ECB’s most recent consumer survey, confidence might be flagging as consumers are preparing for worse times. This negativity consensus can create a cascading impact on the rest of the economy, affecting everything from retail sales to business investment decisions.
With inflation expectations rising, it is crucial for the ECB to avoid any ambiguity in its policy signalling. Clarity about what to expect next will allow consumers to adjust their expectations accordingly and avoid any subsequent dampening effect on economic activity.