Eurozone´s Lowflation

Core Eurozone inflation has fallen to 0.7% during the month of March. Inflation in the Eurozone is already very low, running at an annual rate of just 0.5%. Not only does such a low figure often inhibit economic growth, the current 'deflationary' trend calls for action as the current level is far below the ECB's target of a little below 2%.

The ECB decided to keep its key lending rates unchanged earlier this month, but said that, if needed, it would consider rigorous measures to keep inflation from staying too low for too long. Excessively low inflation makes it hard for stressed countries to regain competitiveness and also makes it more difficult for governments and the private sector to reduce debt burdens.

During the last ECB meeting Mario Draghi stressed that he sees no evidence of a broad-based decline in consumer prices, known as deflation, and that there is no sign people are delaying spending hoping that prices will fall.

Still, Mr. Draghi said "we should not be complacent,". In other words, ‘Eurozone’s lowflation’ is rapidly becoming an issue. Suddenly, the fear of the ongoing ‘deflationary trap’ we are observing in the last couple of years seems to become more and more significant.

European Central Bank President Mario Draghi signalled that deflation risks in the euro region are easing for now after new forecasts showed that inflation will approach their target by the end of 2016. New ECB forecasts underscore his view that the 18-nation bloc will escape a Japan-style period of falling prices as momentum in the economy improves.

"The news that has come out since the last monetary policy meeting are by and large on the positive side,” he told reporters in Frankfurt today after the central bank kept its main interest rate at 0.25 percent. Draghi also indicated that money markets are under control at the moment, lessening the need for emergency liquidity measures.

The exchange rate

Besides the deflationary trend of almost all European countries, a strengthening of the exchange rate of the Euro also contributes quite significantly to some recent short-term slowdown/’slack’ within the European economy.

A strong currency makes an economy's goods and services more expensive in global markets, thereby damping exports. It also weakens inflation by reducing the costs of imported goods, which we do not favor.

The ECB doesn't target exchange rates, but it has highlighted in recent weeks the effect the strong euro has had on inflation, and has said it is an increasingly important factor on the ECB's assessment of price trends. Mr. Draghi recently said a further rise in the exchange rate would trigger additional monetary easing to keep inflation from falling too low.

The euro's rise over the past 18 months "complicates the reacceleration of growth and directly complicates the return of inflation toward our price-stability objective," said Bank of France Governor Christian Noyer. Still, "it seems reasonable to think that the small overshooting in the exchange rate could progressively correct itself" and that the U.S. dollar will rise as its economic recovery advances faster than Europe's.

ECB officials stepped up their rhetoric about the euro last month when the rate approached $1.40. Their comments have not significantly weakened the currency yet, but they appear to have been successful in capping the euro's rise.

Central bank intervention

As Draghi is facing down the threat of deflation in an economy still recovering from a debt crisis that threatened to rip it apart less than two years ago, what to expect from the ECB?

If the ECB decides to act, possible steps include a negative rate on bank deposits parked overnight at the central bank. This would likely weaken the euro by making euro-denominated assets less attractive to international investors--and large-scale asset purchases, which would also influence the exchange rate by raising the amount of money in the banking system.

Obviously, the key question is now whether Draghi’s comments hint at further monetary easing by the ECB in the near future, i.e. at the ECB meeting on May 8 and June 5. Given the elevated level of the euro versus the US dollar, the risk of a rate cut in June has clearly increased. Future action will be data dependent, and we think that triggers for additional monetary easing:

1) disappointing inflations prints that remain far below target,

2) a EUR/USD appreciation well beyond 1.40 and or

3) an “unwarranted tightening” of money markets.

While a rate cut is the most likely first response to the first two triggers, the third trigger would likely cause liquidity measures such as additional long-term refinancing operations or ending the sterilization of the bonds purchased under the Securities Market Programme.

Mr. Draghi has stressed that a bond purchase programme for the eurozone would not be as straightforward as the one in the US. The outright purchase of government bonds may not see money flow to the areas that need it most. Tapping the asset backed securities market may be more beneficial in addressing the region’s financial fragmentation, but the market lacks depth and the total amount of ABS outstanding has fallen significantly since the crisis began. As with most European policies, the design of a robust and appropriate QE programme will take time. Something Europe is short of.

More and more the question ´if´ the ECB will intervene is shifting towards the question ´how´ the ECB will intervene. With the current strengthening of the European exchange rate fears of the ongoing European ´deflationary trap´ have become even more valid. For now, we do expect a small rate-cut, i.e. ten basis points, as most likely to be announced during the next ECB meeting of May 8.

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Ivo Furda

Main interests of Furda are macro­economic developments and trends.

This article provides opinions and information, but does not contain recommendations or personal investment advice to any specific person for any particular purpose. Do your own research or obtain suitable personal advice. You are responsible for your own investment decisions.

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