Short-term inflation expectations among eurozone consumers fell sharply in May, introducing new uncertainty into the European Central Bank's monetary policy trajectory.

According to Bloomberg, the ECB's latest monthly survey showed the median expectation for inflation over the next year dropped from 4.0% in April to 3.5%, a decline exceeding market forecasts. The survey window was from May 7 to June 1, meaning it did not capture the impact of the subsequent US-Iran peace deal, which pushed oil prices back to pre-conflict levels, suggesting actual short-term expectations could be even lower.

However, medium-term inflation expectations remain stubbornly high. Furthermore, the final reading for May's core inflation was revised upwards from the preliminary figure, indicating price pressures are spreading from the energy sector to the broader economy. This combination of data intensifies the policy divide within the ECB: the easing of short-term data may reduce the urgency for aggressive rate hikes, but persistent medium-term inflation and resilient core inflation support the hawkish officials' stance for further tightening.

Markets are now reassessing the rate hike path, and the battle over expectations is heating up. The tension between improving short-term expectations and underlying medium-term structural pressures suggests a policy pivot requires more evidence, and the ECB is likely to maintain a cautious posture, at least in the near term.

Short-Term Expectations Fall, Longer-Term Anchors Remain Elevated

The ECB's monthly survey, released Friday, shows the decline in consumers' one-year-ahead inflation expectations not only reflects a perceived weakening in price rises but also reveals a substantive easing of inflationary momentum within the eurozone economy.

Notably, the survey window predates any substantive steps toward a lasting US-Iran peace agreement. This implies the fall in short-term inflation expectations is not primarily due to the abatement of external geopolitical risks but stems more from weak internal eurozone demand and a self-correcting price transmission mechanism.

However, the decline in inflation expectations is not broad-based. The three-year and five-year inflation expectations, which are more indicative for monetary policy direction, remain elevated at 2.9% and 2.4%, respectively. This structural divergence indicates that while near-term price pressures have eased somewhat, the medium-to-long-term inflation anchor is not yet fully secure, and the stubborn stickiness of core inflation remains a significant concern the ECB cannot afford to ignore.

US-Iran Ceasefire Alters Supply-Side Logic, Forcing Rate Hike Bets Revision

As internal inflationary pressures show some signs of easing, the external macro environment has undergone a major shift. The US-Iran agreement on a lasting peace deal marks a substantive de-escalation of a major geopolitical risk that had been roiling global markets, with international crude oil prices already retreating to pre-conflict levels.

Previously, driven by escalating Middle East tensions and expectations of soaring energy costs, the interest rate swaps market had fully priced in two 25-basis-point ECB rate hikes this year, with the first hike in nearly three years delivered in June. The ceasefire agreement directly interrupts the price transmission chain from geopolitical conflict to energy markets and supply chains, significantly weakening the tail risk of inflation spiraling out of control under extreme scenarios. Consequently, economists and investors are scaling back their bets on the magnitude of subsequent rate hikes.

Marginal Improvement in Macro Outlook Intensifies Central Bank Divisions

Marginal improvements in the macroeconomic fundamentals provide some buffer for the European Central Bank's policy adjustments. The survey shows respondents' expectation for the contraction in GDP over the next 12 months narrowed from 2.2% in April to 1.7%, while the one-year-ahead unemployment rate expectation edged up slightly to 11.3%. The easing of recession fears grants the central bank greater room for maneuver in policy setting.

Against the dual backdrop of receding short-term inflation and diminishing geopolitical risks, internal disagreements within the ECB over the future monetary path are becoming increasingly pronounced. Executive Board member Isabel Schnabel maintains a hawkish stance, arguing that continued strong policy action is still needed to bring inflation back to the 2% target. In contrast, President Christine Lagarde and Chief Economist Philip Lane are more cautious, primarily concerned about downside risks to the eurozone's economic outlook.

This internal tension reflects the policy dilemma currently facing the ECB. Following the 25-basis-point hike in June, the market's previously aggressive tightening expectations are being repriced. The future interest rate path will no longer be dictated solely by geopolitical risks but will depend to a greater extent on the actual evolution of core inflation and the resilience of the underlying economy.