The European Central Bank still doesn’t have a solid grasp on disinflation. ECB president Mario Draghi continues to espouse the view that inflation has bottomed out and will rise slowly back to target “over the medium term”. But there are more disinflation shocks in the pipeline. The ECB needs to engineer a quickening of inflation across the region to avoid deviating further from its increasingly distant inflation target and making deflation an insuperable obstacle to peripheral competitive reform and debt sustainability.
A weaker euro remains the most viable route to this. But this will require substantial monetary easing, a lever that comes with complications.
The ECB has talked about inflation basing out, but headline inflation fell to a lowly 0.5% year on year in March. And this disguises near deflation in most of the periphery EMU states. Indeed, the ECB is forecasting that inflation will be well below the 2% target in three years. Core inflation (excluding food and energy) is already below 1%.
And there are more disinflationary shocks in the pipeline that will further complicate the situation. Producer price inflation is now negative across the region. Further declines in commodity prices suggest this will intensify. Euro appreciation is disinflationary and this trend is being exacerbated by central bank policy, evident in the opposing trajectories of the ECB’s and the Federal Reserve’s balance sheet where there has been a net shift of over €1.75 trillion in the past two years in the euro’s favour.
Emerging market slowdown and weaker emerging currencies will curb developed-world import prices. Chinese rebalancing away from credit-driven investment and the unwinding of the carry trade has negative implications for the price of commodities (raw materials, specifically copper, having been widely used as collateral for bank loans).
So there is a serious risk with deflation. Labour cannot price itself back into jobs because the relative cost of labour versus falling output prices removes any incentive for business to recruit. Furthermore, deflation and low growth play havoc with debt sustainability.
What can the ECB do to avoid deflation? It could trim the repo rate, but another 10 to 15 basis points is hardly going to alter much. It could do another round of LTROs – long-term credit facilities for banks. But how does it make sure the liquidity injected into the system stays there and is lent productively to the real economy rather than being ploughed into sovereign bonds by a still dysfunctional banking system?
A negative deposit rate has been discussed for months as a possible measure. But this comes with as many risks as benefits. It might rekindle financial market stresses, providing an incentive for banks to shrink liquidity. It might provide more direct support to corporates as a way to improve liquidity. But the European corporate debt market is too small and funds pushed this way wouldn’t reach the sectors of the economy that most need it, specifically small and medium-sized enterprises.
All of these steps, then, are tokenism. They won’t get inflation up to the ECB’s target. More is needed: and that more is quantitative easing. The ECB seems to be preparing the markets for its eventual use. However, there are legal obstacles. Even if legal objections can be worked through, there will remain differences regarding the actual criteria to stimulate action. To sidestep objections of monetary financing, the programme would have to be spread across the region and be broader, including at least some purchases of private-sector assets.
I reckon that QE purchases of bonds of around €950 billion (9.7% of eurozone GDP) would bring the central bank’s balance sheet back to its 2012 peak in euro terms. Running a programme of €50 billion to €60 billion a month would be enough to accelerate money supply and critically turn the FX tide. Such an asset-purchase programme should be sufficient to reverse euro appreciation and push the euro back to $1.26.
There are two risks to this strategy. First, if QE is anticipated by markets and assets reprice, it could put implementation on the back burner. Then the currency will not fall as much as it needs to and the kicker to bonds and equities will be less and will be reversible. Second, if Europe still deflates, it would mean QE is ineffective. This would be downright fatal for debt sustainability and the competitive reforms under way in the peripheral eurozone economies.