September 4, 2015 / 2:46 PM / 2 years ago

Volatile oil casts doubt on ECB's future inflation gauge

LONDON (Reuters) - The credibility of one of the European Central Bank’s favourite inflation gauges has come into question after a bout of volatility triggered by wild swings in the oil price.

The five-year, five-year euro zone breakeven forward EUIL5YF5Y=R, which President Mario Draghi often cites and which the ECB considers when it sets policy, is designed to measure what inflation is expected to average between 2020 and 2025.

It should also strip out near-term fluctuations in, for example, commodity prices.

However, in recent days it has moved almost in lock step with the most violent oil price swings in six years, complicating the picture of inflation expectations as far out as 2025.

“This is not a reliable measure given the massive swings we have seen in correspondence with oil price moves,” said Marco Valli, chief euro zone economist at UniCredit.

Draghi cited the rate in a speech at last year’s Jackson Hole gathering of central bankers to warn of declining inflation expectations.

A sharp fall in the rate towards the end of 2014 was one of the main justifications for the ECB to launch its trillion euro bond-buying programme in March.

“If you pin yourself to only one thing, it might save you in certain periods, but it may also put you in a straitjacket,” said Dariush Mirfendereski, global head of inflation trading at HSBC.


The breakeven forward rate is not the ECB’s only measure of inflation expectations but analysts say Draghi mentions it rather less often these days.

He did not refer to it in his news conference this week even as he unveiled lower inflation forecasts and warned of a possible slip back into deflation.

Ben May, lead euro zone economist at Oxford Economics, said the ECB was trying to distance itself from the measure, worried that investors are “becoming a little bit too obsessed with it”.

Economists are hesitant about predicting the impact of energy prices on inflation more than two years into the future.

Yet this week an 8 percent rise in Brent crude LCOc1 sent the five-year, five-year rate to a three-week high of 1.72 percent, up from a six-month low of 1.62 percent just a week earlier when crude hit a six-year low.

The five-year, five-year forward rate is derived from five- and 10-year inflation swap rates. All are actively traded in the market and this could be part of the problem.

Most investors try to make a quick profit by buying or selling these swaps instantly. Few invest with the view to holding the asset until in matures in 2025, and that is why factors like sudden oil price moves gain such focus.

“All of these measures will be driven by the quirks of the way the inflation markets behave and investor psychology, and you always have to take that into consideration,” said Mirfendereski at HSBC.

That is why many economists, including UniCredit’s Valli, prefer survey-based measures of inflation. The ECB has been eager to stress in recent meetings that it takes an array of measures into account.

Questions about the reliability of the five-year, five-year rate echo general disillusionment with inflation forecasting.

Based on the ECB’s inflation forecast from September last year, consumer prices should be growing at 1.1 percent. In fact, they grew at just 0.2 percent in August and are predicted to be just 0.1 percent by the end of the year.

Many still expect the ECB to put less emphasis on the five-year, five-year forward in the future, although it would be hard to completely ignore it.

“It is the main indicator Draghi looked at when the ECB launched sovereign QE, so it will be difficult for them to back-pedal at this stage as their credibility would suffer,” said UniCredit’s Valli.

Graphic by Alasdair Pal; Editing by Nigel Stephenson/Ruth Pitchford

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