Understanding Inflation Expectations and Their Impact on EUR/USD: Insights from Commerzbank

The recent meeting of the Federal Open Market Committee (FOMC) has sparked significant discussions in the financial markets, particularly regarding potential interest rate cuts. Speculation is rife that the Federal Reserve may implement substantial cuts of 50 basis points instead of the previously anticipated 25. This topic is not only relevant for the Fed but is also being considered in the context of the Swiss National Bank (SNB), the Riksbank, the Bank of England, and Banxico, according to Ulrich Leuchtmann, Head of FX and Commodity Research at Commerzbank.

Current market expectations indicate that inflation in the Eurozone is projected to be a mere 1.7% over the next year, which is significantly below the European Central Bank's (ECB) target. This low expectation is illustrated in the data presented in figure 1. While it is acknowledged that these market expectations may carry a risk premium, this factor alone cannot account for the subdued inflation outlook in the Eurozone. Notably, the inflation expectations for the following twelve months (1Yx1Y) are also low, at 1.77%, suggesting that the market is not merely hedging against short-term inflation but is genuinely anticipating low inflation rates.

In contrast, if US inflation remains stable around current levels (with the Consumer Price Index (CPI) recorded at 2.5% in August), the implications of similar monetary policy actions by both the Fed and the ECB must be evaluated differently. The ECB's measures are likely to have a lesser impact on reducing the real interest rate of the Euro compared to the Fed's influence on the USD real interest rate.

It is important to highlight that Commerzbank's economists do not align with the prevailing market sentiment regarding inflation. They forecast that Eurozone inflation will gradually approach the 2% target, without falling below it, and may even hover slightly above this target. Consequently, the medium-term forecast for EUR/USD is primarily based on the expectation that the market will be caught off guard by inflation rates exceeding current predictions.