Should the ECB aim for an inflation overshoot?

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The account of the ECB’s January monetary policy meeting revealed that the Governing Council’s concerns about the inflation outlook had built significantly since the previous meeting in December. Officials expressed concern that ‘weaker than anticipated growth in wages, in conjunction with declining inflation expectations, could also signal increased risks of second-round effects’. These developments ‘had again increased the probability of the euro area economy remaining in a low inflation environment for an extended period of time’.

There tentative signs of a stabilisation of investor sentiment following the torrid start to the year, though sentiment remains fragile Nick Kounis Nick Kounis Head of Macro Research

  • One of the ideas discussed at the ECB’s January Governing Council meeting was the case for aiming for an inflation overshoot..

  • …given declining credibility of the inflation goal and rising risks of second round effects, there is a strong case for ‘doing too much’…

  • …as aggressive easing could help to push up inflation expectations

  • Meanwhile, there were signs of a stabilisation in investor sentiment as oil prices firmed and economic data eased fears of recession

  • The minutes of the Fed’s January meeting signalled a gradual departure from further early interest rate hikes

Action in March a done deal, but will the ECB convince?

We think that further stimulus in March is a done deal, the main open question is exactly what the ECB will do and how aggressive it is willing to be. There are clearly differences in this among Governing Council members. At least one official made the case for aggressive action saying that ‘it appeared logical from a medium-term perspective for the Governing Council, after a prolonged period of undershooting of its inflation aim, to consider a limited period of overshooting in future’.

ECB should now aim to ‘overdo it’

This idea was treated with derision by some commentators as the ECB is far from its goal and apparently is struggling to push up inflation even a little. However, the idea actually makes sense. Long-run inflation expectations have fallen to record low in recent months. This reflects a number of factors. First, inflation has been low for a long time. Since Mario Draghi became ECB President in November 2011, headline as well as core inflation have averaged just 1%. Granted during the era of his predecessor Jean-Claude Trichet inflation did average 2%, but even then, core inflation was just 1.5% (see charts below). Furthermore, the eurozone has faced headwinds for growth and inflation recently and the ECB has been rather timid in dealing with them. The package it delivered in December was rather modest and there was arguably a strong case for the ECB to ease again in January, while it decided to consider its options and act in March.

Investors need to believe that the ECB is willing to do ‘whatever it takes’ and more. If the ECB announces a much larger package of measures than expected, that could help to push up inflation expectations as investors and the public become more convinced in the ECB’s determination to act. That could prevent companies, investors and individuals continuing to assume that inflation will remain low in their price and wage setting behaviour.

20160301-Inflation under Jean-Claude Trichet20160301-Inflation under Mario Draghi 

ECB to move interest rates deeper into negative territory

We expect the ECB to cut its deposit rate by a cumulative 40bp to -0.7% over the coming months. We see the reductions taking place in two steps of 20bp, in March and June.

Many have worried that this will deliver a big blow to bank profitability and thus could be counter-productive. For exactly this reason, we expect deposit rate cuts be accompanied by measures to cushion the blow for the banking system. The most likely step is a move to a two-tiered deposit rate system, so that commercial banks pay the higher penalty rate on a smaller proportion of their excess reserves. Other possibilities to support the banking sector are refi rate cuts and new TLTROs.

Finally, we expect a stepping up of QE (of EUR 10bn per month). This should be facilitated by dropping the deposit rate floor for purchases, which would increase the eligible universe of government bonds the ECB could buy.

Tentative signs of stabilisation in investor sentiment on oil accord

Meanwhile, there tentative signs of a stabilisation of investor sentiment following the torrid start to the year, though sentiment remains fragile. Global equities have firmed over recent days and indices tracking implied equity volatility declined. However, equity markets still remain sharply down compared to the start of the year and implied volatility remains somewhat above its historical average. Sentiment has been supported by a stabilisation in oil prices following an agreement between Russia, Saudi Arabia and Venezuela and Qatar to freeze output at January levels. The key take away from the accord seems to be that the a number of big producers are not happy to tolerate oil prices much below USD 30 per barrel.

Economic data mixed, but not consistent with recession

Another relatively supportive factor is that economic data cast some doubt on the recession scenario that markets had been pricing in. That is not because the data are great. In fact they are rather lacklustre, but are more consistent with ongoing weak growth rather than a major downturn. For instance, US industrial production jumped by 0.9% in January. That was well above consensus, but did follow a 0.7% contraction in December, so the underlying trend is still rather subdued. Indeed, though the Empire State Manufacturing Index rose in February, it is still as very low levels. Meanwhile, housing starts fell for the second consecutive month in January. This series is volatile, but home builder confidence also softened in February, albeit from relatively high levels.

Turning to Europe, Germany’s ZEW economic sentiment indicator dropped for the second month in a row in February. The part of the survey that gauges analyst expectations about the German economy during the next six months declined further below its historical average. That said, the ZEW survey is very much driven by sentiment in financial markets and most evidence remains consistent with weak economic growth. At the same time, eurozone consumer confidence also fell in February, though it remains above historical averages.

FOMC focus on downside risks

Finally, the minutes of the FOMC’s December meeting suggested that the Committee is increasingly concerned about downside risks to the economic outlook following the turbulence on financial markets. Some participants noted that ‘ the effects of these financial developments, if they were to persist, may be roughly equivalent to those from further firming in monetary policy’. We expect the Fed to leave interest rates on hold during the rest of this year.

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