The European Central Bank (ECB) again kept all policy levers unchanged at its February 2014 Governing Council meeting, emphasising the eurozone’s fragile recovery and signaling its readiness to ease policy further, if needed. The ECB has been very transparent as to how it will react to either an unwarranted tightening of financial conditions or an unwelcome negative shock to the inflation outlook. The pertinent question we need to ask going forward will be: What is the likelihood of these two events – or, for that matter, a strengthening of the recovery – to unfold over the current policy’s relevant time horizon?
At this point, we see only a small likelihood of money market financial conditions tightening owing to homegrown problems in the months ahead. The ECB’s commitment to fixed rate, full-allotment refinancing operations until mid-2015 should ensure adequate liquidity. Symptoms of eurozone fragmentation are gradually abating as banks strengthen balance sheets in preparation for this year’s comprehensive banking system balance sheet assessment, and policy initiatives in some member states are delivering real progress on economic adjustment.
But the likelihood of insufficient demand that causes inflation to undershoot, or the likelihood of the recovery gaining momentum, are finely balanced. We see three reasons why the risks are increasingly tilted toward too little inflation becoming the dominant issue in 2014.
First, the disinflation trend is broad-based across the eurozone. All countries are contributing to lower inflation. It is not just the internal devaluations of programme countries that are pushing eurozone inflation down. At the beginning of 2012, core countries contributed 1.8% to the eurozone’s then-3% inflation.
It is now 0.7%, of which 0.6% comes from core countries (see Figure 1). So while core eurozone countries’ share of total inflation has risen, their rate of inflation has fallen by two-thirds. The disinflation trend in non-programme countries, chiefly Spain and Italy, is also trending precariously downward. Were Italy, as well as France, to embark upon its much overdue structural reforms as other peripheral countries already have, overall eurozone inflation would markedly decline further.
Second, capital outflows from and policy tightening in emerging markets coupled with turmoil in global stock markets early this year present cyclical disinflationary headwinds for the eurozone. Although the eurozone current account surplus has grown in recent years in part due to periphery countries absorbing less and Germany diversifying exports to emerging markets, weaker emerging market demand and currencies will exert mild disinflationary forces on the eurozone via lower import and energy prices. Also, weaker global stock markets are not conducive to a recovery from very low investment levels in the eurozone.
Looking further ahead, the opening up of the European Union’s labour market this year to citizens from Romania and Bulgaria will help to keep a lid on eurozone wages. Immigration of workers from Spain and Italy to Germany, and with the possibility of that extending to Central European countries as well, is one reason why wages in Germany are not rising despite record low unemployment in the country. That is a good sign of labour market flexibility.
And third, the issue goes beyond the narrow focus on inflation – it is about growth and debt sustainability too. ECB Vice President Vitor Constâncio recently noted, “The treaty says that provided price stability is insured we should pursue other objectives, like unemployment and growth. Clearly there is a secondary mandate”. Clearly, the ECB has achieved price stability. A low rate of nominal economic growth and low inflation pose a number of issues for the eurozone, which the ECB should take into account.
When inflation is low for prolonged periods, hysteresis – to borrow from physics – can dislodge inflation expectations from their desired path. A widely held view among experts is that eurozone inflation will remain low this year and next, owing to internal devaluations and balance sheet adjustments, only picking up in the years ahead. Indeed, the ECB staff’s central inflation forecast is 1.1% for 2014, rising to 1.3% in 2015. Survey-based indicators of inflation expectations show that respondents in periphery countries, unlike core country respondents, expect lower prices going forward, while the ECB’s survey of professional forecasters sees future inflation (two to five years out) anchored more closely to 2%.
We would be cautious in reading too much into these surveys of inflation expectations. Households’ responses to future price expectations tend to be influenced by their current or recent experiences, and there is a degree of circularity to the professional forecasters’ survey. We suspect that they always say inflation will be about 2% two to five years out because professional forecasters assume the ECB will act to achieve its goal, i.e., they think the ECB is credible.
At PIMCO, we view the declining trend of market-based measures of inflation expectations with a note of caution. Expectations for future eurozone inflation for 2016 and 2017 have fallen to about 1.4%. If these medium-term measures of inflation expectations begin to approach 1%, it will signal that the ECB’s credibility is waning and heighten the need for a policy response.
Long periods of low inflation and growth are not an issue when public and private debt levels are low. But too little growth and inflation for too long become a different issue when debt levels are high. Low growth makes it challenging for debtors to remain current on servicing their obligations and could reignite the sovereign debt crisis. Sovereign debt sustainability requires a combination of low interest rates, adequate primary budget surpluses and sufficient nominal growth. If growth does not pick up over the medium term, investors’ confidence in the sustainability of Italy’s sovereign debt, for example, which the International Monetary Fund forecasts to reach 133% of GDP this year, could resurface.
The right mix
We therefore see inflation risks tilted to the downside, not balanced as the ECB observes, implying the possible need for a more accommodative policy later this year. If the ECB would embark on such an asset purchase programme, how large would it be and what would it buy?
We think the ECB would have to purchase a significant amount of assets. The M3 money supply gap – the gap between current M3 and the level implied by its long-term trend – amounts to €1.4 trillion at present (see Figure 2) and can serve as one top-end range indicator for the size of a potential quantitative easing (QE) programme. The longer the current trends persist, the greater the gap and the risk of deflation and debt unsustainability. ECB President Mario Draghi appeared to recognise this risk during his recent attendance of the 44th World Economic Forum Annual Meeting in Davos (Switzerland) last month, commenting, “The longer it stays at a low level, the more serious risk of deflation”.
At the same time, Mr. Draghi also set a high bar for the ECB to buy bonds. In Davos, he alluded to the ECB not buying government bonds, which we will designate as QE, stating that, “First of all, we have a Treaty that says, that prohibits, monetary financing. So we don’t have a gilt programme like in the UK, we don’t have a government bond programme like in Japan or in the United States”. Were the ECB to buy assets this year or next, it would prefer to buy bank loans, which we will designate as credit easing. However, we do not think Mr. Draghi’s plan as alluded to will work.
Plain vanilla asset-backed securities (ABS), with transparent look-through to underlying assets, do not exist in the quantities needed for an asset purchase programme to be effective, nor does the ECB have the expertise to buy loans bilaterally from banks – although it will gain experience in this field through the asset quality review currently underway. Likewise, while covered bonds are a substitute to ABS, this sector is relatively small and illiquid. We believe that an asset purchase programme consisting of loans, covered bonds and government bonds is thus more realistic were the ECB to stimulate policy further. And we think it would buy assets broadly in line with the ECB’s capital key.
Mr. Draghi’s Davos comments suggest a far-off contingency plan using an asset that does not exist to thwart a deflation threat the ECB does not perceive. PIMCO’s inflation forecast for 2014–2015, at just over 1%, is probably not low enough for the ECB to consider further easing necessary; however, the recovery is fragile, the balance of risks to both growth and inflation tilted to the downside, and another negative external shock would certainly tip the scales.