Taking the temperature of inflation

Inflation is, by definition, a lagging statistic. By the time official CPI prints confirm that price pressures are rising or easing, markets have already spent weeks, often months or even years, trying to anticipate that outcome. That is why fixed income investors spend so much time on market-based measures of inflation expectations. They are imperfect, but they offer a forward-looking view of where inflation is expected to settle across different horizons. So before asking what inflation means for markets today, it is worth starting with how those expectations are measured, and how they help investors and policymakers judge the appropriate central bank response.

The starting point is the inflation-linked bond market. These securities compensate investors for realised inflation by linking either principal, coupons, or both to an inflation index. In simple terms, they allow investors to separate “real” returns from inflation compensation. Comparing the yield on a nominal bond with the yield on an inflation-linked bond of similar maturity gives a breakeven inflation rate, the rate at which an investor would be indifferent between the two. This rate provides an estimate of average inflation expectations over that period.

This cash market naturally gives rise to a derivatives market. Inflation swaps allow investors to exchange a fixed inflation rate for realised inflation over a given period, without having to trade the underlying bonds. In practice, swaps are often a cleaner way to read market pricing because they isolate inflation more directly and can be observed across a wide range of maturities. That makes them especially useful for tracking how inflation expectations evolve from the very short end of the curve to the far end.

One of the most closely watched points on that curve is the 5y5y forward inflation swap. This is the market’s implied inflation rate for the five-year period that begins five years from today. In other words, it is not a view on where inflation will be next year or even over the next five years, but rather on where inflation is expected to average in years six through ten. That matters because it removes much of the noise linked to near-term energy moves, base effects, and temporary shocks. For central banks and long-term investors, it is a useful gauge of whether inflation expectations remain anchored. It is not a pure measure of expectations, as risk premia and market technical factors also play a role, but it remains one of the best market-based proxies for long-run inflation credibility.

That distinction is particularly important in the current market backdrop. Euro inflation expectations were extraordinarily low for much of the period before COVID, and arguably for much of the market’s history. During episodes of acute stress, including the global financial crisis and the 2020 shock, market-implied inflation rates fell sharply as growth concerns dominated and markets priced in weak demand and persistent disinflation. Inflation, for a long time, was something policymakers were trying to generate, not suppress.

That changed decisively in the post-COVID period. Reopening dynamics, supply chain disruptions, fiscal support, and then the energy shock following Russia’s invasion of Ukraine pushed inflation expectations sharply higher. The move was most visible at the front end of the inflation curve, where markets had to reprice the near-term path of headline inflation very quickly. Longer maturities moved as well, but by much less. That was an important signal: the market recognised a severe inflation shock, but did not fully abandon the view that inflation would eventually return closer to target.

The latest move fits that pattern. As the attached EUR inflation swap chart shows, short-dated inflation expectations have risen significantly again. The one-year swap has moved notably higher, and the two-year sector has followed. That is consistent with a market that sees renewed upside risk to near-term inflation, most clearly through energy and other geopolitically sensitive inputs. Events in the Middle East have added another layer of uncertainty, and the front end is where that uncertainty shows up first.

The more interesting point is what has not, at least yet, happened. Longer-dated inflation swaps, including the ten-year sector and the 5y5y forward, have moved higher, but only modestly compared with the front end. In other words, the market is repricing the near-term inflation path, not yet a persistently higher inflation regime. That is a meaningful distinction. A front-end sell-off in inflation pricing can reflect immediate supply shocks and risk premia. A decisive move in the 5y5y would suggest something more concerning: that investors are starting to question the medium-term anchoring of inflation expectations.

For now, that does not seem to be the message. The shape of the curve still suggests that the market expects current inflation risks to fade over time rather than build further. Short-term inflation expectations have become more unsettled, but longer-term expectations remain broadly anchored. For fixed income investors, that is the key takeaway. The market is still drawing a line between temporary inflation pressure and a lasting loss of anchored expectations.

The question now is whether this remains a relative price shock or begins to generate broader second-round effects. By second-round effects, we mean the process by which an initial rise in energy or other input costs feeds into wages, services prices, and wider pricing behaviour across the economy, keeping inflation elevated for longer even after the original shock fades. That is the risk central banks will need to monitor closely. At the same time, they will also need to recognise that this type of shock is likely to weigh on real incomes and underlying growth momentum. The policy challenge is therefore one of balance: containing any signs that temporary price pressure is becoming embedded, without tightening so aggressively that it deepens the drag on activity. For now, with longer-term inflation expectations still broadly anchored, the case is stronger for vigilance than for a mechanical policy response.

EUR inflation swap rates

Source: DPAM, Bloomberg, 2026