Jury remains out on ECB deflation-fighting plans

Justin Pugsley
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Draghi attempted to convince markets at Thursday’s press briefing that the ECB has officially awarded itself some new monetary policy tools – with the most dramatic being QE – as it frets over the prospect of the eurozone sliding into deflation.

Quantitative easing (QE) is hardly cutting-edge these days, as it has been deployed elsewhere, but its use could still be a game-changer for the euro in that it could create a bear market for the single currency.

However, will it happen?

Mario Draghi, president of the European Central Bank (ECB), is widely credited in the FX markets for being a deft communicator.

Some of his verbal interventions, such as the “whatever it takes to save the euro” speech in July 2012, rank among the most effective in recent memory. It reversed the existential crisis rapidly engulfing the then floundering euro.

So was Thursday’s press briefing one of those moments?

Draghi let it be known: “The [ECB’s] governing council is unanimous in its commitment to using also unconventional instruments,” adding that measures such as QE have been actively considered.

The ECB attempted to convince markets all manner of policy tools are now up for grabs. It is concerned the eurozone might be teetering on the edge of a deflationary abyss – where economies stagnate as consumers delay purchases and companies investment plans.

Apart from QE, there’s the potential for negative deposit rates, currently at zero, through to more variations on the theme of refinancing operations for banks. Some unconventional monetary tools, particularly QE, have been considered akin to monetary heresy in Germany.

Yet one of its staunchest opponents, Bundesbank chief Jens Weidmann, who also sits on the ECB’s governing council, has dramatically softened his stance recently towards measures such as QE.

However, this probably isn’t a conversion on the road to Damascus.

“Viewed from the perspective of dealing with deflation, QE appears much more acceptable,” says Jonathan Loynes, chief European economist with Capital Economics.

And the spectre of deflation does appear to be looming larger. Inflation in the eurozone was a mere 0.5% in March, down from 0.7% in February and well below the ECB’s 2% target.

During the height of the eurozone crisis, QE would have been closely associated with indirectly funding struggling peripheral member states. For Germany this was a non-starter. In its eyes it would have been an excuse for struggling peripheral states to delay fiscal consolidation.

According to Loynes, the use of QE is also unlikely to contravene the ECB’s mandate as long as the bond purchases are conducted in the secondary market. “If they bought corporate bonds, it would be even less associated with potentially funding countries,” says Loynes.

However, as Draghi points out, most financing is done via banks in Europe. In other words, the corporate bond market is relatively small. Yet Draghi seems keenest to aim any stimulus as squarely as possible in the direction of the private sector. Hence he wants to revive the asset-backed securities market – but doing so is unlikely to be in time to form part of a stimulus package.

It depends on the deflationary outlook:

Euro-area annual inflation and its main components (%), April 2012 - March 2014. Source: Eurostat 

Despite the excitement by some commentators, QE is unlikely to happen soon, if at all. “As the ECB said, conventional measures have not been exhausted,” says Brian Martin, senior European strategist with ANZ. “The ECB may never even use QE.” Martin says its use depends on the trajectory of eurozone inflation numbers. Draghi says a number of seasonal factors drove inflation lower in March, suggesting a possible rebound in April. Bayern LB is looking for 0.7% to 1.0% for that month. As Loynes states, a clearer picture might not emerge until May, when the data should be less distorted by seasonal factors. Therefore, unconventional intervention by the ECB could still be months away.

In a research note, Barclays Capital doesn’t see unconventional instruments, including QE, being utilized by the ECB until year-end. For the time being, talking the currency down is one way to go and that box was ticked at the press conference, though boosting eurozone inflation would require a substantial and sustained devaluation. Low inflation, capital inflows, the recovering eurozone economy and a large current-account surplus all conspire for a strengthening euro. The main refinancing rate at 0.25% could be cut to zero, but that might not have much effect either.

The euro could behave a bit like a cork in water that stubbornly keeps bobbing up, despite the ECB’s best verbal efforts to keep it down. Many analysts are warning that the most recent verbal intervention, if it is to work, will have to be backed up by action. Fortunately for Draghi, he appears to be well kitted out for a long campaign against deflation – if that’s what it takes.