"The ECB’s New Math: 5+5=QE"

From Real Time Economics:

There is a new “it” indicator in Europe: the five-year, five-year swap rate.

It may look like a typo, but this index has generated rampant speculation in financial markets that the European Central Bank will launch a large-scale program of public and private debt purchases—known as quantitative easing or QE—in the next few months.

ECB chief Mario Draghi made it famous at his Jackson Hole speech Friday when he noted that financial measures of inflation expectations have weakened.

“The 5-year/5-year swap rate declined by 15 basis points to just below 2% – this is the metric that we usually use for defining medium term inflation,” Mr. Draghi said.

Financial markets have rallied since. Bond yields are down in Europe, and equities jumped. The euro has lost ground on hopes for more aggressive ECB efforts to fight low inflation and spur stronger economic growth.
So what is this new best friend of QE advocates? The index measures investors’ bets on what the inflation rate will be starting in five years and lasting another five. If the swap rate falls, investors expect less inflation. It’s not a perfect measure—no gauge of inflation expectations is—but the ECB likes it, and that’s what counts.

And here’s why it matters: Mr. Draghi has said that if the ECB thought the longer-term outlook for inflation was eroding, then QE would be an appropriate response. With annual inflation just 0.4% in July—far below the ECB’s 2% target—any weakening in price expectations raises the risk that too-low inflation will become entrenched....MORE