Economist Insights

Looking forward to it

7 April 2014Asset management

Not all misses in inflation are created equal. Once again, Eurozone inflation surprised the market to the downside last week, coming in at 0.5%. Yet once again the European Central Bank (ECB) has failed to act. It is hard to imagine the ECB sitting idly by if inflation were missing the target by an equivalent amount to the other side. In fact, last time inflation was at 3.5% (back in 2008), the ECB promptly hiked rates. Bad timing as it turned out; Lehman went bust two months later and the financial crisis kicked off.

To be fair, a low inflation number was always likely because of the timing of Easter this year relative to last year. Nevertheless, the underlying number may actually be even weaker, because increases in value added taxes (VAT) in France actually inflated the number by 0.2% according to Eurostat. The underlying level of inflation may well be dangerously close to zero.

Over the last couple of weeks some members of the Governing Council of the ECB, including even the Bundesbank president, have voiced increasingly dovish rhetoric. Furthermore, it seems that quantitative easing (QE) was explicitly discussed during the last ECB meeting. Given dangerously low inflation and hawks apparently turning into doves, it is legitimate to wonder why the ECB did not take any action.

One way to interpret the reasoning of the ECB is that it is being forward looking, so it does not react to today’s data. After all, monetary policy acts on the economy with a long lag of around 9–15 months. When a central bank makes its monetary policy decisions, it has to take into account not just the current state of the economy, but also the expected developments in the future.

On that score, the recovery may well remain weak but forward looking indicators have improved remarkably. Most of the survey indicators have been on an upward path for the

past year. Furthermore, the gap between the indicators in the core and those in the periphery of the Eurozone appear to be closing, suggesting the improvement is becoming more widespread (see chart 1). This improved confidence about the future was also evident in the latest ECB forecasts for growth.

Is the improvement in economic confidence enough to justify the ECB ignoring the extremely low level of current inflation and the risks that come with it? Is the ECB running the risk that trend inflation becomes stuck at a lower disinflationary level, or even worse in a Japanese style deflation? The ECB continues to see these risks as limited and contained. Just look at the fact that it took no actions in March despite downgrading its outlook for inflation. At the same time, as reiterated last week by President Draghi during the press conference, the ECB continues to assess the risks to its inflation outlook as limited and balanced.

Joshua McCallumSenior Fixed Income EconomistUBS Global Asset Managementjoshua.mccallum@ubs.com

Gianluca Moretti Fixed Income EconomistUBS Global Asset Managementgianluca.moretti@ubs.com

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Why did the ECB not announce any action last week following the release of very low Eurozone inflation figures? Surprisingly, the ECB does not seem too concerned about the risk of disinflation or even deflation. To understand the ECB’s position, it is important to look at the factors which have been keeping inflation low.

Chart 1: Feeling good

European Commission economic sentiment indicators (100 is the long-term average)

Source: European Commission, Eurostat, UBS Global Asset Management

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To understand the ECB’s position, it is crucial to identify which factors have been keeping inflation low and, in particular, whether it is down to a negative demand shock or a positive supply shock. A negative demand shock is how most people think about disinflation, and it can usually be identified because inflation falls at the same time as activity decelerates. Conversely a supply shock can be identified as a situation where inflation falls but activity accelerates. If inflation was pushed down by a demand shock then it would have been a mistake for the ECB not to have taken actions to support demand. When the economy is hit by a supply shock a central bank will be more likely to remain on hold, especially if the supply shock is an external shock.

While the economy is usually driven by a mix of supply and demand shocks, the ECB is apparently thinking that part of the weakness in inflation is linked to a positive supply shock in food and energy commodity prices. In the past, when the ECB thought that demand shocks were dominating, it took action. The ECB may well now be thinking that the supply shock is dominating since inflation is falling but activity is accelerating, plus survey indicators suggest that it will continue to do so at a faster pace.

The risk of cutting rates in the face of a positive supply shock is that it might over-stimulate domestic demand, especially consumer spending. Lower prices from the positive supply shock will already have improved real wages and household purchasing power. Lower inflation can also enhance overall consumer confidence: periods of low inflation make households feel richer and this makes them feel better (chart 2). This in turn makes them feel more confident about their future financial situation and their willingness to spend more on large purchases.

In theory one of the risks is that the stimulus to domestic demand from lower commodity prices could boost the domestic component of inflation and as soon as commodity prices bounce back inflation could end up above target. However, this would be true in a context where the output gap in the Eurozone was nil or positive. But with the output gap expected to remain negative for an extended period of time in many Eurozone countries, higher domestic inflation does not seem a realistic threat. In this context, further action could actually help to close the output gap faster.

A more concrete threat is that the very low levels of foreign and domestic inflation could become entrenched in inflation expectations and bring trend inflation lower. At the same time, since the Eurozone is far from being an optimal currency area, there are also longer-term risks that could come with this, and in particular to the rebalancing and deleveraging process (as highlighted in Economist Insights, 17 March 2014).

So if the ECB is entirely right in its forecast, then perhaps it is justified in staying on hold. But when was the last time that everything went according to plan? From a risk management perspective, the ECB’s strategy looks a bit dangerous. Markets interpreted last week’s press conference as more dovish because the possibility of QE was raised. Nonetheless, the ECB gave the impression that the conditions that could trigger QE are still quite remote. In the meantime, a policy rate or deposit rate cut could have wider effects than the ECB might anticipate. True, it might not do all that much for the economy given the challenges in the banking sector. But it would do a lot to reassure people that the ECB will not tolerate continually low inflation. Crucially, this would help to keep inflation expectations well anchored: the way people look forward to inflation is often self-fulfilling.

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InflationFinancial situation next 12 m. (rhs, inverted)

Major purchases (rhs, inverted)

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Chart 2: Feeling the (purchasing) power

Consumer expected financial situation for the next 12 months, current climate for major purchases (standard deviations from the mean) and Eurozone inflation

Source: European Central Bank