The chart below speaks volumes. It shows where the ECB thinks Eurozone inflation will be in 2 to 3 years’ time. What the chart tells us is that since the Great Financial Crisis, the ECB has never expected inflation to rise by enough to hit its 2% mandate. Following last week’s Monetary Policy meeting, the ECB is now forecasting that after many years of continuous growth (since 2012 when the peripheral Eurozone crisis hit a low), with the output gap almost closed and with the unemployment rate homing in on pre-crisis lows, the ECB may achieve 1.6% inflation in three years’ time and will therefore still miss its inflation target. Throw in the typical “forecast errors” which, for the ECB have typically leaned towards the optimistic side, and the actual miss may turn out to be even greater; not 1.6% inflation, but perhaps something closer to 1.5% or lower.
Last week the ECB became the latest major Central Bank to move monetary policy in a more dovish direction. The ECB provided guidance that its negative deposit rate will remain unchanged until at least the end of 2019, an extension worth at least three months longer than their previous guidance for unchanged rates “through the summer of 2019”. Of greater surprise was the earlier than expected timing of their announcement of a new targeted longer-term refinancing operation (dubbed TLRO-3) where banks will be given incentives of progressively cheaper loans from the ECB in return for growing their non-mortgage loan books relative to last month’s baseline. The ECB also made significant cuts to their growth and inflation outlook, with 2019 Eurozone GDP growth expected to be only 1.1%, down from the previous forecast of 1.4%, and core inflation is expected to rise by only 1.2% this year. The most striking aspect of their projections was the above-mentioned downward revision of their medium term inflation forecast to only 1.6%.
Will this easing be enough? Most likely not. We do not think that last week’s ease will be the ECB’s final move in this direction. The next move is likely to still be another ease otherwise the ECB is at risk of de-anchoring inflation expectations. Indeed, some even question whether the ECB might be able to tighten and move rates away from negative before the next recession hits!
Compared with a Federal Reserve who are pretty much at their inflation target and yet publicly considering running inflation a little hot for a while longer in order to make up for past undershoots, the ECB looks somewhat lethargic in comparison. In a way, the ECB’s structural inflation miss is hardly a surprise. The Bundesbank is strongly against having an inflation rate of more than 2% in Germany and with the ECB’s target set at 2%, countries such as Italy must run a lower inflation rate, call it 1%, in order to improve its export competitiveness relative to Germany and other countries in the Eurozone “core”. In this environment, the average should therefore typically come in well below 2%. With low growth and low inflation, concerns regarding unsustainable debt trajectory for some Eurozone countries such as Italy will regularly come to the fore. We believe that with the Fed paving the way and potentially making it explicit that monetary policy will aim to deliver 2% inflation on average over time, other global central banks will follow suit. Otherwise these targets may continue to act as ceilings, thereby leaving less room to avoid deflationary pressures when the next crisis hits.
Speaking of crisis, it is difficult to avoid using such a term when it comes to Brexit. The Withdrawal Agreement (WA) has been rejected by the House of Commons twice and although an extension of Article 50 looks inevitable, we are unable to predict with confidence how the Brexit process will eventually play out. A third attempt to pass the Withdrawal Agreement is likely to be made next week, this time with MPs facing the choice of voting for the WA or being confronted with a long extension of Article 50 and rising risks of having no Brexit at all. For the UK economy and financial markets, all the confusion is extremely unhelpful. But we believe that with the budget deficit running at a low 1.1% of gdp, the UK government has sufficient fiscal headroom to provide the economy with spending support should Brexit stresses lead to a further significant slowdown in the economy. In addition, the Bank of England will be ready to ease monetary policy through rate cuts should a significant growth slowdown lead to increasing risks that they fail to hit their inflation mandate. With Bank Rate at only 0.75%, there isn’t a significant amount of room to cut rates before we are faced with the “zero lower bound” again and QE will likely have to be restarted. Again, all the more reason for global Central Banks to ensure that they lift growth and inflation so as steer economies well clear of deflationary forces come the next global recession.