Investors’ inflation expectations in Europe fall to lowest level since 2022

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Closely watched indicators of long-term inflation expectations in Europe have hit their lowest levels in nearly two years, a sign that investors believe central banks can cut interest rates further without risking a flare-up of price pressures.

The eurozone's so-called five-year forward inflation swap – a measure of markets' view of price growth in the second half of the next decade – fell below 2.1 percent this week for the first time since October 2022, after standing above 2.3 percent last month.

Meanwhile, the pound's corresponding inflation swap – which tracks retail prices, which tend to rise by about 1 percentage point more each year than consumer prices – has fallen to 3.2 percent from 3.5 percent in April, close to its lowest level since 2016.

“This is a big step,” said Tomasz Wieladek, chief European economist at T Rowe Price. “I think investors are moving away from their fears of stagflation and are expecting a demand-led slowdown.”

Inflation concerns have eased as investors focus on the risks of a global recession, especially after a weak US jobs report in early August prompted a significant rethink on the prospect of interest rate cuts by the US Federal Reserve.

Inflation expectations in the US have also fallen in recent weeks. Markets are pricing in an average long-term inflation rate of 2.4 percent, compared to 2.6 percent in July. This was boosted by the US Federal Reserve recently describing the new data as “strengthening its confidence” that inflation is approaching its target of two percent.

“Growth data was rather weak and the disinflation trend appears intact,” said Mohit Kumar, chief European strategist at Jefferies. “Both point to lower inflationary pressures.”

Thursday's figures also showed that wage growth in the euro zone slowed significantly in the second quarter, underpinning the European Central Bank's case for its second interest rate cut for the second quarter of this year next month.

In the eurozone, collectively agreed wages rose by 3.6 percent in the quarter compared to the same period last year. In the previous three-month period, the annual growth rate was 4.7 percent.

“In Europe, the negotiated wage data have helped to allay any earlier concerns about continued wage pressures,” said Richard McGuire, head of interest rate strategy at Rabobank.

British wage growth, which has contributed to stubbornly high inflation in the services sector, is also showing signs of slowing: in the three months to June, the annual increase slowed to 5.4 percent from 5.8 percent in the previous month.

The decline in inflation expectations has also been accompanied by a decline in global commodity prices, led by oil and gas and key metals such as copper and iron, which have pushed Bloomberg's commodity index down by more than 10 percent since May.

Analysts said slowing demand from China for key commodities was contributing to lower inflation expectations globally.

“Not only is China making things like cars much cheaper, the economy is also slowing down and that is creating overcapacity in things like steel, which the country then tries to export,” Wieladek said, adding that demand for European luxury goods has also fallen.

But while inflation expectations have fallen, analysts also warn they are likely to remain volatile. Europe's ageing population and shrinking workforce could increase wage pressures in the long term, and the likelihood of a labour shortage in the UK is “even greater”, says Rabobank's McGuire, due to immigration restrictions imposed by Brexit.

Fiscal policy demands such as higher defense spending and massive investments to finance the climate transition could increase public spending and increase inflationary pressures, analysts say.

“I do think inflation is coming down, but … one thing I'm concerned about is fiscal policy,” said Jefferies' Kumar. “Sub-2 percent is perhaps a story for early 2026.”