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Monday, February 03, 2014

Are further falls in inflation putting more pressure on the ECB to act?

Friday saw the release of the flash estimate for annual inflation in the eurozone in January. It dropped further to 0.7% - well below the ECB’s target of 2%.

The initial reaction was that this will increase pressure on the ECB for action at this Thursday’s Governing Council meeting. While that is true on the surface its worth keeping another couple of points in mind.

  • As the graph above shows (click to enlarge), much of the recent decline has come from changes in energy and food prices. Core inflation, excluding these two factors, has been relatively stable since October and has been on a gradual decline since spring 2013.
  • Now of course, many will point out that energy and food are important components of real world costs and therefore should not be discounted. This is a valid point, but here we are looking for insight into how the ECB takes its decisions. Generally, the ECB will be less concerned over short term moves in energy and food prices and is therefore less likely to take action off the back of this.
  • The main part of the decline took place last year and has been happening for some time – this is likely already accounted for in the ECB easing efforts.
  • While the inflation data may not push the ECB to act, there are plenty of other concerns. The turmoil in Emerging Markets could push the ECB to provide an additional liquidity buffer against any shocks. While this morning’s PMI manufacturing data was actually very positive for the eurozone, data on lending to the real economy and growth of the money supply is less so.
As we have suggested before, some further easing is looking likely. The real question is when and how? The data suggests to us that the ECB will wait until its March meeting and its updated inflation forecasts to make a judgement – but then again it went a month earlier than expected in November.

As for how, the most likely tools remain some form of targeted LTRO and/or purchases of bank loans but both programmes would require significant work and have numerous shortcomings, as we have already noted.


Rik said...

It is about time the EZ and also the ECB makes their minds up.
-Go for a 2% inflation target; or
-Go for internal devaluation.

It is either or. Only a pure theoretican can think you can reduce costs only for goods to be exported and not at the same time internally.

Anyway it would be both absolute crap policy choices:
-the internal devaluation goes way too slow plus one completely ignores that because it took all so long the curve has changed. Starting up new activities simply has another (worse) curve/math than extending existing ones. Furthermore investing decisions are now simply delayed. In a normal enviroment people go partly with the cycle now almost everybody waits.

2% inflation overall in a zone where half simply will hardly see any price risies, means close to 4% in the rest.
Do this with low interest and over a long term and you are simply blowing bubbles (and big ones) in the North. New crisis in the making while the prior one is not even half way.

Jesper said...

Inflation - central to economic theory and (therefore?) not well understood.

Lets just break it down into two different kinds of inflation:
-wage-inflation that can drive cost-inflation
-cost-inflation due to increased cost of inputs. Cost-inflation is unlikely to have an effect on wage-inflation in todays world. The reason being that international trade is common and outsourcing to low-wage countries is a reality.

Increased costs, the measured inflation, for wage-earners are unlikely to allow for extra spending by wage-earners nor is it likely to make it easier for wage-earners to pay back borrowing.

How can increased costs make it easier to spend more and/or pay back borrowing? Or are the problems not lack of spending and huge debt-overhang?

Stefan said...

In fact, the ECB's inflation target is not 2%, as it's "below - but close to - 2%".

Jesper said...

Might add that since the "financial plumbing" still have the same bottlenecks - the local banks. Increasing liquidity is unlikely to deal with the problem of bad/insolvent banks.

Also, there is the talk of 'inflating away' the debt. I'd assume that the term refers to increase wages (wage-inflation) to make it easier to pay back borrowing. If that is the case, why bother measuring cost-inflation when the interesting factor is wages and wages can be measured with greater accuracy? (Assuming income statements provided to taxation authorities are accurate.)

How many can negotiate an increase of salary based on increased personal costs? My experience has been that it is a lucky and tiny minority who can do that.

christina speight said...

It's about time the ECB recognised the perils of the looming deflation trap. As inflation falls so inevitably does GDP and as debt stays constant the percentage of debt to GDP soars upward.

The makings of the next crisis ?