Inflation consternation

Martin Harvey, Fund Manager, Threadneedle International Ltd | November 5, 2013

  • An inflation slowdown in the Eurozone has prompted calls for central bank action, as reduced liquidity coupled with euro strength threatens the recovery.
  • The expectation of imminent easing by the ECB should assert downside pressure on yields, and lead Bunds to outperform other markets.
  • It is uncertain whether the ECB will act this week; we think any intervention is likely to be verbal, at least at first.

October inflation in the eurozone slowed alarmingly to levels not seen since late 2009. Some commentators have been quick to change their call for European Central Bank (ECB) action on November 7 or the December meeting. Previously, ECB President Mario Draghi has said lower inflation due to factors such as energy prices is actually positive, as it boosts disposable income and hence consumption. For sure, some of the October decline comes from energy base effects given that annual energy inflation fell to -1.7% year over year. But this doesn’t explain all of it.

From a country perspective, a lot of the drawdown is driven by the periphery, given the output gap impact from base effects associated with value added tax (VAT) hikes in 2012. In Italy, a VAT hike in October 2013 of 1% was not enough to prevent a fall in the headline inflation measure, suggesting the output gap impact is dominant. This should have been broadly expected given the recessionary environment and is not new news. This is likely seen as a healthy step towards competitive advantage.

The recent strength in the euro has added to the downward pressure. Combined with energy base effects, if all else remains unchanged, the Harmonized Index of Consumer Prices (HICP) is due to converge back towards 1% in coming months, so maybe this is the trough. However, a lack of action from the ECB could push the euro higher and cause more pain, keeping inflation below 1% for a prolonged period.

Markets have moved to price in a reaction from the ECB, but levels are still above the levels reached earlier in the year. Improved economic optimism and correlation with the U.S. led to some level of normalization in the euro rate curve. The expectation of imminent easing by the ECB should assert further downside pressure on yields, and lead Bunds to outperform other markets.

Rather than easing, monetary policy has actually been in tightening mode in recent months, as excess liquidity has drained from the system following early Long-Term Refinancing Operation (LTRO) repayments. This adds to the case for the ECB to act, but there has been limited impact on overnight rates thus far. Reduced liquidity coupled with euro strength threatens the recovery.

The longer term concern surrounding deleveraging continues to reflect a downside risk to pricing pressures. Loan growth remains in negative territory as banks shrink their balance sheets, and balance sheet shrinkage is likely to continue for some time.

ECB policy options:

  • Do nothing. It could be argued that the depressed level of inflation is transitory and actually positive for consumption. Inflation expectations fell following the release, but are not low compared with some extreme points of the last five years. Therefore, Draghi could ascertain that expectations remain anchored. The emerging recovery will slowly close the output gap, aided by low rates and forward guidance.
  • Change language to ‘Inflation risks are to the downside.’ Until now, inflation risks have been stated as broadly balanced. An acknowledgement of downside risks would be an important signal, and highlight an imminent policy response.
  • Refi rate cut to 0.25%, keep deposit rate at 0.0%. It is questionable what impact this would have, but the communication impact of moving closer to negative rates, alongside a verbal reference to a negative rate possibility would potentially be powerful. However, this would likely not slow the repayments of LTRO cash.
  • Refi rate 0.25% and depo rate cut 0.25%. This should have an immediate impact on the exchange rate, for which it has been stated that such a policy would be intended. However, it does seem like something of a last roll of the dice, so I imagine they would attempt to talk about it for a while before acting. There are evident problems with negative rates that some on the council are not comfortable with, so the hurdle likely remains high.
  • Extend forward guidance to highlight inflation threshold. The council has been uncomfortable with such suggestions in recent months, but a signal that rates will remain low until Consumer Price Inflation (CPI) is above 1.5% for example is a potential move. This would push yields lower.
  • LTRO fixed rate-full allotment. Alongside a refi rate cut, this appears to be at the forefront of discussion at present. This could potentially be effective in stemming the reduction in excess liquidity but doesn’t evidently impact the inflation outlook. Given that banks may be paying back LTRO cash ahead of the Asset Quality Review date in December, this has the potential to backfire.
  • LTRO fixed size at competitive rate. I have not seen anyone suggesting that this is possible, but I see this as a neat way of forcing liquidity in the style of quantitative easing (QE), but maintaining the ECB’s preference for a self-correcting mechanism since the money would come back automatically.
  • U.S.-style QE. Remains a distant prospect.

It is uncertain whether they will act this week, but this is largely due to a lack of viable options rather than not wanting to. A 25 basis point rate cut seems both an easy decision and a futile one. We think intervention is likely to be verbal, at least at first. The staff forecasts will be updated in December and will likely show downward revisions to the 2014 CPI forecast (currently 1.3%) and potentially a low number for the first estimate of 2015. This should be enough to force the acknowledgement that inflation risks are to the downside, which as noted, should necessitate some form of response. The response however, is unlikely to be as aggressive as is required.

The improving growth outlook should keep yields away from crisis lows, but the post-recessionary range of 1.70-2.05 in 10-year Bunds has given way to a break into the previous range 1.10-1.70. The threat of policy action should bias yields lower over the next week ahead of the ECB meeting, and possibly beyond if the ECB acts or at least threatens to act, which is now likely. A defiant Draghi could turn this around if he is not concerned by the inflation numbers, but that could potentially harm inflation expectations further.

In the longer-run, the threat of deflation and on-going growth challenges will continue to cap yields on a sell-off. All-in-all, Europe and especially the periphery tick a number of the boxes that lead to comparisons with Japan. For all the competitiveness gains, nominal GDP growth that is crimped by falling prices will put further pressure on ever-rising government debt-levels. That will become a problem at some point.

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Martin Harvey

Fund Manager, Threadneedle International Ltd
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