The latest myth of a European recovery came crashing down two weeks ago when Eurostat reported an inflation print of 0.7% (putting Europe's official inflation below that of Japan's 1.1%), followed promptly by a surprise rate cut by Mario Draghi which achieves nothing but sends a message that the ECB is, impotently, watching the collapse in European inflation and loan creation coupled by an ongoing rise in unemployment to record levels (not to mention the record prints in the amount of peripheral bad debt).
Needless to say, all of this is largely aggravated by the soaring EURUSD, which until a week ago was trading at a two year high against the dollar, and while helpful for Germany, makes the so-needed external rebelancing of the peripheral Eurozone countries next to impossible. Which means that like it or not, and certainly as long as hawkish Germany says "nein", Draghi is stuck in a corner when it comes to truly decisive inflation-boosting actions.
But what is Draghi to do? Well, according to BNP's Paul-Mortimer Lee, it should join the "no holds barred" monetary "policy" of the Fed and the BOJ, and promptly resume a €50 billion per month QE.
Why? Some preliminary perspectives from BNP:
Some economies in the eurozone are already in deflation. This has adverse effects on resource allocation (nominal rigidities in some prices mean that relative prices do not adjust enough) and, of course, sets in train adverse debt dynamics. It deters spending today, because things will be cheaper tomorrow. When significantly negative real interest rates are warranted, zero or negative inflation makes these impossible to achieve. Countries that are undergoing structural reform need lower real interest rates than they would otherwise have. Extremely low or negative inflation, therefore, militates against structural reform.
One fact sums up the parlous state of affairs: the eurozone has lower inflation than Japan (0.7% versus 1.1%).
At such low levels of inflation, deflation is a real danger. How big a threat is it? The inflation forecasting literature says that since the Great Moderation, the best way to forecast inflation over longer periods is a random walk. (Over short periods, judgemental forecasts, (eg, taking account of energy prices, tax increases etc) are preferable.) A random walk model says that decreases in inflation are as likely as increases. If we start from 0.7% inflation, the central forecast of a random walk model will be that inflation stays around its current level, ie, that deflation is less than 50% likely. Our own forecasts agree with this but also – like the ECB judges – indicate that inflation will remain at very low levels for a very long period.
Why has inflation in Europe proper not become outright deflation across the continent, especially when considering the record low rate of growth (in reality, contraction) of loans to private sector companies? The only silver lining are "inflation expectations" which are still anchored somewhere aroun the 2% area. However, that may not last.
If inflation expectations break down, then as rates are close to the zero bound, getting them back up again could be extremely difficult. In fact, it may be impossible. Don’t wait until you are drowning to think about looking for a lifejacket. That is one of the lessons of Japan, waiting until too late can leave you locked into an insoluble problem.
Why then did the hawkish members not want a rate cut? It is difficult to be sure but we suspect it is a combination of strategic and tactical considerations (our comments in parentheses):