DRAGHI MISSED THE CHANCE TO ACT ON INFLATION / THE FINANCIAL TIMES COMMENT & ANALYSIS

May 18, 2014 6:35 pm

Draghi has missed the chance to act on inflation

By Wolfgang Münchau

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QE might not work precisely because it has been left too late

The European Central Bank saved the euro by providing a backstop to the member states of the single currency in 2012. That at least is the current received wisdom. I wonder, however, whether that will still be the judgment in two years’ time. Future economic historians may view the ECB rather differently. They might say the ECB actually misread the eurozone economy in 2011-2013 and failed to provide enough monetary stimulus.

Just look at the latest data. The economic growth figures for the first quarter, released last week, were awful. Large parts of the eurozone are shrinking again. The forecasts for this year will now have to be revised downwards. Yes, strong growth in Germany kept the eurozone above water during the first quarter, but Europe’s biggest economy is now actually slowing down. As growth falters, inflation rates will remain soft for some time to come.

To what extent is this the ECB’s fault? We know that economies suffer periods of low growth after a financial crisis because various sectors pay off debt simultaneously. The ECB itself has actually been one of the better forecasters. Mario Draghi has consistently said that the recovery would be weak and fragile – an assessment that is now proving correct.

What the president of the ECB misjudged was the impact of the weak recovery on inflation. There seems to be something wrong with the economic model the ECB is using. It did not see the fall in inflation coming. It did not see it getting stuck at current levels.

Headline rates of inflation started to fall off a cliff last November. More illuminating is core inflation – which excludes volatile items such as food and energy – that dropped below 2 per cent for the first time in January 2009, more than five years ago. It fluctuated around 1.5 per cent for a long time until it fell to 1 per cent in April 2013. It fell again last October. Since then the average rate has been a little over 0.8 per cent.

What we have seen is a very gradual and persistent decoupling of inflation rates from the ECB’s target of 2 per cent. Producer prices have been deflating for almost a year. The growth of broad money is also weak. 

Overall prices are not yet falling, nor about to fall any time soon. That would require another shock. But bringing inflation back to the original target may not happen either. That, too, would require a shock – in the opposite direction.
Ideally, we should not have to start from here. But we do. So, what can the ECB do now?

In his most recent press conference Mr Draghi said that he would be “comfortable with acting next time”. What I found far more interesting was an earlier speech he gave in Amsterdam. There he went through a number of “what if” type scenarios with admirable clarity. One of those was the one we are now in: a worsening of the medium-term outlook for inflation. And this is what he said about this particular scenario: 

“The limited margin for manoeuvre that remains over short-term interest rates would not be sufficient. This would be the context for a more broad-based asset purchase programme.” Another central banker-speak term for “broad-based asset purchase programme” is, of course, quantitative easing.

If the recent media reports are true, the ECB will not embark on QE in June. Instead, it will cut the main interest rates by a fraction. It will impose a negative interest rate on deposits held by banks at the ECB itself. 

It may also encourage banks to lend money to small and medium-sized companies; it may enact some subtle changes to the way it injects liquidity into the markets. But no QE. Given what Mr Draghi said in Amsterdam, it will be interesting to match such a decision to his words. Logically, only one of three things can happen: either he will say he is not much concerned about inflation after all; or he will resort to QE after all; or he will change his mind. Each would be a surprise.

The ECB is facing a genuine dilemma – beyond the usual difficulty of getting everybody lined up behind a common policy. QE might not work precisely because they have left it too late. A year ago, QE might have stopped the appreciation of the euro, one of the factors behind the fall in inflation. A bigger programme would be needed to have a similar effect today.

My expectation is that QE will happen eventually because the data are simply too bad for the ECB’s governing council to ignore. But the programme will either be too late, or too small, or both. The result is that inflation rates are likely to be anchored at close to 1 per cent – roughly 1 percentage point below the official target.

The long-term implications of such a new normal inflation rate are hard to overstate. It would make it impossible for Greece and Italy to meet their debt-reduction targets. At 1 per cent inflation, the probability of debt default increases. At 1 per cent inflation, the eurozone crisis has a higher probability of returning than under the previous target.

Inflation of 2 per cent – whatever it takes. This is the assurance that Mr Draghi should have given.

Copyright The Financial Times Limited 2014.