Inflation – a midsummer night’s dream?


The current economic situation in the euro area is rather interesting in terms of monetary policy going forward. It is interesting for one, because the ECB governing council needs to balance between anchoring inflation expectations and ensuring financial stability in the euro area. Ultra low bond yields and refinancing rates are boosting solvency figures in terms of long term debt sustainability, especially in the weak sovereign sector. However, inflation seems to be slowly picking up as well.

QE is supposed to enter its peak phase in terms of the size of the consolidated balance sheet of the eurosystem by next year. I guess the maturing bonds will be reinvested for a long time before the eurosystem starts to actually delever its balance sheet. Debt sustainability should be ensured from the financial stability perspective and therefore I do not expect the ECB to start outright selling any time soon. If inflation picks up in an unexpected way, I would presume it would be a safer option to first raise the interest rate corridor upwards. This would flatten the yield curve.

Since late 2014, inflation expectations have been stabilised and the spectre of deflation in the euro area has disappeared for now. QE and the ultra low interest rate corridor have increased substantially the amount of bank lending and money is created in the economy at a decent pace. Investment and consumption is growing, unemployment is falling, currently around 9,3 %. This is all good. However, if inflation expectations would increase substantially, monetary policy stance would need to change sooner and the yield curve would shift upwards faster than anticipated. This could be a problem for some countries with a large stock of public debt, weak external balance (current account deficit and negative NIIP) and low nominal GDP growth. Housing price developments in countries like Germany could also contribute to a tighter stance of monetary policy albeit something could be done with macroprudential tools as well. Cyclically raising capital requirements to shrink bank lending would be a continuation of monetary policy by other means.

Let us therefore spend some time to analyse the current monetary situation in the euro area. First, headline inflation (HICP) is actually close to the target range of the ECB. It is currently around 1,4 %. Core inflation nevertheless is stuck around 0,9 %. Moreover, market based inflation expectations indicators like the 5y5 forward swap are showing some deceleration tendencies and thus lower future inflation. M3 annual growth is around solid 5 %, which is telling us that things are indeed more stable than they used to be. Even in the US, M3 growth is reassuring. The Chinese credit bubble might induce some problems here as  well though, although in China crisis management could be more straightforward. Current account is in surplus for the euro area as a whole, while the NIIP is still largely negative. The external balance would therefore indicate that the euro is more or less correctly priced in the forex markets. So imports induced inflation should stay more or less stable.

Oil price is around 45 $, and the trend is downwards, but I would assume OPEC will cut production further in order to stabilise the developments there. One can say that oil price is not forcing the central bank to raise rates. Political uncertainty in the US, North Korea, Syria and Russia might trigger a surge in risk premia, but for the time being nothing acute seems to be happening. Of course Brexit and the looming Italian elections add to the political uncertainty as well.

Eurozone growth seems to be broad and solid especially in Germany and France and the recent PMI figures suggest that this is indeed the case, although there was a little correction from the peak figures recently. For the euro area as a whole, 2 per cent growth for this year seems totally realistic. Unemployment is trending downwards as well, going towards NAIRU, what ever it is in the Euro area.

So, in terms of monetary policy, my guess is that the ECB will stop net buying during 2018 and will start raising rates in 2019. Due to financial stability concerns, raising the interest rate corridor would be my choice of weapon. Happy Juhannus (midsummer night) and stay safe.


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