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Inflation's return to negative territory increases pressure on the ECB

Eurozone inflation turned negative again in February (-0.2% over one year), for the first time since last September.

Admittedly, this poor number is due to an unfavourable base effect related to the price of oil (which had temporarily rebounded in February 2015). This effect should gradually dissipate and, after a few months in slightly negative or zero territory in the first half, in our scenario of slow economic recovery, headline inflation will gradually rise again (see graph). Even another, very hypothetical, drop in the price of oil would only delay this rebound, with the effect of a change in oil prices on inflation diminishing as the price falls (as its share in the total cost of fuel, and of energy in general, becomes smaller).

In reality, the unpleasant surprise of February's inflation numbers comes more from core inflation (+0.7%, the lowest in a year, and only one-tenth above its all-time low), and, especially, inflation of services (less subject to international trade than goods, and therefore less influenced by the euro's movements). In February, the increase in services prices stood at 1% over one year, its lowest level since the euro's creation (already reached in early 2015).  While the economic recovery has ultimately been a little more vigorous than projected in 2015, this deceleration is especially troubling. The worst is not certain, and perhaps that is due in part to statistical volatility and the deferred transmission of oil price's decline to other sectors. No doubt a (small) part of this weakness is itself virtuous, the effect of reforms carried out in recent years to heighten competitiveness on the service market and drive down excessive margins and prices in the interest of the consumer and, ultimately, of growth.

Yet sticking to these explanations would wrongly minimise global deflationary pressures. With doubts about the recovery and the global economy in general increased, downside risks to inflation prospects have risen recently. Pessimism regarding euro zone inflation outlook is stronger than ever: professional forecasters expect inflation of just 1.6% in 2018 and market-based long-term inflation expectations have strongly dropped recently and reached new historical lows. A possible unanchoring of inflation expectations is a risk that the ECB cannot and does not want to take.

Although the ECB appears forced to take new easing measures to safeguard its credibility, the question remains over which tools it could use to do so. Following the Governing Council meeting held in December (cut in the deposit rate to -0.30% and time extension of the PSPP), the euro climbed and long-term inflation expectations plummeted as the markets were expecting an increase in the pace of asset purchases. The latter is likely to be announced by the ECB on 10 March, but this will not come without problems relating to its implementation. In recent weeks, the Bundesbank has been forced to buy bonds with much longer maturities than usual, as German securities with a maturity of less than seven years do not respect the PSPP’s yield constraint (under the PSPP, the yield of securities purchased must exceed the deposit rate). According to our estimates, assuming that bond yields remain at their current level (which is obviously not realistic), the Eurosystem would not be able to find sufficient German and supranational securities to maintain the PSPP until March 2017. For this reason, and also to maintain downward pressure on the euro, it is highly likely that the deposit rate will be further lowered. For the ECB, the challenge will be to find a system that will not overly penalise the profitability of the banks, which would put the distribution of credit to the private sector at risk.  

 

2016-03-04-focus
Tristan Perrier Bastien Drut & , Strategy and Economic Research at Amundi
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Inflation's return to negative territory increases pressure on the ECB
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