Inflation in the Euro Area at 0.5% is too low and expectations on the ECB are probably too high

An inflation rate at 0.5% in May is clearly too low. But with contributions from energy and food sectors at 0, it means that this low inflation rate has nothing to do with commodities. It’s related to internal weakness of the Euro Area. Some specific factors (Easter,…)can be put perceived as an explanation but it is just an impact of +/-0.1% and does not explain the very low trend of the inflation rate. Moreover, due to uncertainty in measures, at 0.5% the probability of already being in deflation is not null.

There are three plus one factors that can explain this situation

The first is the absence of growth and of pressures on the production system. Internal demand is weak, as is demand for exports (the improvement of the trade surplus comes mainly from lower imports). So, pressures on costs are dramatically reduced and then not creating conditions for a higher inflation rate. Another reflexion here is the following: the will to reduce government expenditures to balance public finances could weaken internal demand then increasing the risk for deflation.

The second reason is the absence of tensions on wages. Low pressures on the labor market, uncertainties in which can employees be on the labor market and a still high unemployment rate are explanations for this situation. Germany seems to be the only one that can change the picture. But productivity gains seem to have been kept by companies. New entrants on the labor market have deteriorated conditions compared to their elders.

The third factor is the current strategy seen within the Euro Area. As internal demand is weak, every country wants to develop a low cost strategy that can improve its competitiveness. Here again, pressures on prices are very limited and eventually feed deflation.

The extra factor is a strong euro level (and this will not change as the huge current account surplus is here to stay). All these factors are not related to commodity prices but put a downward pressure on prices.

What can the ECB do?
The ECB has an inflation target at 2%, it has to take in charge the inflation rate trajectory and its convergence to this target. But it’s more complicated than that, as the current inflation rate reflects the difficulty for almost every country of the Euro Area to converge to a strong and sustainable growth rate. The perception wa can have is that every economic agent try to balance its own situation, to be risk neutral, expecting that the ECB will be able to make the adjustment, to make the change that could improve the global picture and at the end to take the risk in charge. That’s probably too much. With that in mind, it seems that there are probably too many objectives for too few instruments. Economic policy tells us that to be efficient, the number of objectives and of instruments must be equal.
With that in mind we probably expect too much from the ECB.

On the instruments’ issue, there are deep discussions within the Eurozone on the type, the moment and the amount of it. At next Wednesday meeting, Mario Draghi is expected to announce technical measures to reduce the volatility of the money market (the refi rate will be lowered to 0.10 or 0.15%, the deposit facility rate will drop in negative territory and liquidity measures are expected to reduce this volatility (It will stop the sterilization of the SMP portfolio. Currently, this operation doesn’t work efficiently and stopping it could bring extra liquidity)).
Mario Draghi is also supposed to announce operations that could boost the macroeconomic picture. It has to be a support for the inflation rate to converge to its target (even if it is between 2017 and 2020) and Mario Draghi wants it to improve internal demand momentum. That’s what he said when he wants to boost the financing of small and medium size companies. We know that his preferred instrument would be to buy ABS. The interesting point would be to reduce the risk taken by the banking system. The idea is that banks make loans, securitized them and sell it to investors or to the ECB. Banks in that case would not take too much risks and that could be important in some peripheral countries. But the current regulation on securitization is too constraining for banks and that explains the current narrow ABS market. The ECB and the BoE try to change the regulation but it is not the case yet and this instrument cannot be use efficiently.
We cannot expect a QE of the type that was put in place by the Fed. We know that buying sovereign bonds is not allowed on the primary market contrary to what the Fed can do.
Will it be a new LTRO as it was done in 2011 and 2012? Probably not. So it could be a conditional LTRO? The liquidity provided would be conditioned by a pre-define type of financing for banks. Can an operation of this type have a large impact? That’s a question even if the demand for credit was on the upside in the last ECB surveys.
Will this type of operation be announced next Thursday or later after banks’ balance sheet analysis (next fall)? And what can be the amount? Can it be the equivalent of USD 85bn per month as the Fed did during its QE3? Probably not.

In other words, the second instrument, beside interest rates, seems to be of a limited size and very specific. We cannot expect a large operation as the Fed did.
But then we are all at the eve of a deception on the ECB role.
We are expecting too much of the ECB action. Growth and a higher inflation rate are targets for everyone. The ECB can ease the adjustment but cannot do the whole thing.

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