For western economies, the Iran conflict fits the textbook description of an adverse supply shock that lowers real activity and raises inflation. By how much inflation will rise and over what horizon depends on many variables: how long the conflict lasts, how quickly firms can substitute between inputs, how connected sectors are to the energy sector, how fiscal and monetary policy respond, and how expectations of private agents react (Taylor 2026, Lane 2026, Waller 2026). Inflation expectations play a central dual role. On the one hand, they summarise how economic agents weight the various determinants of future inflation. On the other, they are themselves a key driver of inflation through their influence on household saving decisions, wage demands by workers, price-setting by firms, and portfolio choice by investors. Accurate, real-time measurement of inflation expectations would therefore go a long way to improve assessments of the inflation outlook and the conduct of monetary policy (Ascari and Trezzi 2025).

How to measure expected inflation in real time?

Most survey measures are available only at monthly or quarterly frequency, are released with a lag, and reflect the sluggish updating to news by respondents. Separating noise from signal in survey data in real time is difficult. An alternative measure of expected inflation that is easily accessible at high frequencies is the price of an inflation swap contract or of an inflation-indexed government bond. These data reflect the beliefs of traders who are continuously responding to news, which is particularly helpful when there is a dizzying flow of information about the conflict, the economy, and the response of policy. Moreover, these prices accurately distinguish between shorter and longer horizons, allowing for an assessment of the persistence of inflation shocks.

A severe limitation, however, is that market prices move not just in response to fundamentals but also in response to frictions that shift the demand and supply of the underlying financial contracts. In Bahaj et al. (2025), we document that the market for inflation swaps is segmented between different institutions. As a result, changes in pension funds’ hedging needs, or changes in dealer banks’ balance sheet capacity or risk-bearing constraints will shift demand and supply, respectively, even when there is no news about inflation. Around large shocks and elevated uncertainty, this problem may be worse.

Market pricing of inflation in the UK vs. the US vs. the euro area

Figure 1 plots in black the raw price of inflation swaps for three major western economies (UK, US, and euro area, in rows) and for both a short-run one-year horizon and a long-run ten-year horizon (in columns). The measure of inflation is the Retail Price Index (RPI) in the UK, Harmonised Index of Consumer Prices (HICP) in the euro area, and Consumer Price Index (CPI) in the US, and these are average year-on-year inflation rates expected over the next one (ten) years. The plots start four weeks before the conflict (2 February) and end ten weeks into it (8 May), with 28 February marked by a vertical grey bar to denote the start of the active conflict. We normalise the value on 2 February to zero, to focus on the changes that followed. 

Figure 1 Market-implied expected inflation during the Iran conflict

Taking the raw market prices (black line) at face value, UK expected inflation over the next year has risen by around 2.5 percentage points (pp), and by 1.5 percentage points in the euro area since the onset of the active conflict (top and middle rows, left column). Swap rates increased sharply in the first two weeks of the conflict, then stabilised, before rising again from mid-April. 

These moves appear puzzlingly large. By contrast, the four-quarter-ahead forecast for CPI inflation published by the Bank of England’s Monetary Policy Committee (MPC) increased by 1.75 percentage points between the February 2026 Monetary Policy Report (MPR) and the April 2026 MPR. Survey-based expectations moved even less: in the Consensus Economics survey of professional economists, one-year expected inflation rose by only 0.84 percentage points and 1.07 percentage points for the UK and the euro area, respectively, between 27 February and 15 May.

In the US, raw market pricing of one-year inflation swaps is likewise puzzling, but in the other direction. Unadjusted inflation swap rates increased for the first two weeks, in line with the UK and the euro area, peaking at 0.8 percentage points relative to late February. However, there was a sharp decline at the very end of March, and swap rates in early May were lower than before the war started. This pattern is not evident in other available projections. For comparison, the Consensus Economics forecast for the US increased by around 0.8 percentage points since the onset of the active conflict.

Turning to the ten-year measures in the right column, swap rates in all three jurisdictions have risen by around 0.2 percentage points since the onset of the active conflict. This may give rise to some concern for policymakers focused on anchoring inflation expectations. But, if frictions are behind the puzzling movements in the short end, perhaps they are distorting the view of anchoring in the long end as well.

The value of focusing on ‘fundamental’ inflation 

In Bahaj et al. (2025), we use the segmentation in the market for inflation swaps to decompose observed swap rates into a ‘fundamental’ component – risk-neutral expected inflation, which moves when both demand and supply shift with fundamentals – plus a frictional component, which moves when only demand or only supply of the market becomes more constrained or more eager to trade. The paper proposes three complementary empirical identification strategies (heteroskedasticity around inflation data releases, granular instruments from institution-level trading, and sign restrictions exploiting the segmentation between short- and long-horizon trading desks) and implements them using confidential trade-level UK data. In an ongoing revision, we have extended the sign-restriction approach to use only publicly available Bloomberg data on one-year and ten-year swap rates and the corresponding trading volumes. That portability makes it possible to investigate what happened to expected inflation in the UK, US, and the euro area over the past three months.

Figure 1 decomposes the unadjusted market price into two components. The first is the fundamental expected inflation that is shared by all sides of the market, shown in red. The second is a frictional component that reflects shifts in the demand (or supply) of these contracts for only one side, shown in blue. Confidence bands for each estimate are shown as shaded grey areas to reflect the uncertainty in the statistical method behind this decomposition. 

Four findings, once frictions are cleaned out

First, the frictional component of prices in all three currency areas moved significantly during the war, on some days accounting for almost all the movement in swap prices. That frictional component holds very little signal for a monetary policymaker focused on the market’s true assessment of forward inflation. At short horizons, frictions and fundamentals were positively correlated, so shifts in the demand and supply for inflation protection and the news about inflation move in the same directions. Finding 1: Market prices exaggerated movements in fundamental inflation expectations at short horizons.

Second, UK fundamental one-year inflation expectations have risen by 0.84 percentage points, more than in the euro area or the US. Once the frictional component is stripped out, the UK rise is smaller than the raw 2.5 percentage points but still substantial, and it matches the Consensus Economics survey. In the euro area, the corresponding rise is around 0.4 percentage points; in the US, also around 0.4 percentage points. The ordering of the perceived intensity of the shock – UK most exposed, euro area, and US less so – mirrors the actual intensity of the inflationary spike that followed Russia’s invasion of Ukraine in 2022. Finding 2: Market pricing of fundamental one-year-ahead inflation has increased more in the UK than in the euro area or US.

Third, the US one-year fundamental component rose but the frictional component fell sharply during this period. Raw prices provided a misleading view of what was happening to fundamental expected inflation. Finding 3: For the US, raw market prices understate the rise in fundamental inflation expectations at both short and long horizons.

Fourth, because frictional shocks are larger in the short end than the long end, raw prices understate the perceived persistence of the inflation shock. In the UK, fundamental expected inflation over the next ten years has risen by roughly one third of the increase in the corresponding one-year ahead measure, while in the euro area and the US the increase is closer to one half. For context, a purely transitory one-year shock would imply a response closer to one-tenth. Figure 2 illustrates the extent of persistence by backing out the implied change in fundamental expected inflation over years two to ten: across jurisdictions this is around 0.16 percentage points. Finding 4: Markets expect inflation to be elevated beyond one year across jurisdictions.

Figure 2 Market-implied fundamentals point to persistence beyond one year

Implications for inflation and monetary policy 

As of now, fundamental inflation expectations remain well-anchored at longer horizons across jurisdictions. Nevertheless, market-implied fundamental inflation over years two to ten has increased by roughly 16 basis points, indicating that inflation pressures are expected to persist beyond the one-year horizon. The fear is that what currently appears as moderate persistence may compound if the conflict continues. The advantage of our proposed approach is that it allows these developments to be tracked in real time as the conflict evolves. A lesson for researchers and policymakers is that the raw swap prices should be filtered out of their frictional distortions to recover cleaner signals for monetary policy and macroeconomic analysis. Frictionless markets are a useful theoretical benchmark, but they do not describe the conditions under which inflation swaps are actually traded. 

References

Ascari, G and R Trezzi (2025), The Research Handbook of Inflation, Edward Elgar.

Bahaj, S, R Czech, S Ding, and R Reis (2025), “The Market for Inflation Risk”, CEPR Discussion Paper 20157.

Lane, P (2026), “Analytical Perspectives on Energy Supply Shocks”, Dinner remarks by Philip R. Lane, Member of the Executive Board of the ECB, at the Centre for European Reform, 13 May.

Taylor, A (2026), “Stopping for Gas”, Speech given at the Exante Data 10 Year Anniversary Conference, New York, 26 March.

Waller, C (2026), “Policy Risks Have Changed”, Speech at the Centre for Central Banking Guest Lecture, Frankfurt School of Finance and Management, Frankfurt, Germany, 22 May.