ECB paralyzed by split as irreversible deflation trap draws closer

4/12/2014

By Ambrose Evans Pritchard

'It is now patently clear that Draghi lacks the crucial German support for launching full-blown QE'

The European Central Bank has dashed hopes for quantitative easing this year and acknowledged for the first time that the institution’s elite board is split on plans for a €1 trillion liquidity blitz.

Equity markets fell across southern Europe,with Italy’s MIB off 2.77pc, led by sharp falls in bank stocks. Spain’s IBEX dropped 2.35pc.

The euro surged by more than 1pc to $1.2455 against the dollar in early trading as speculators rushed to cover short positions. Expectations for immediate stimulus had been riding high after the ECB’s president, Mario Draghi, pledged action “as fast as possible” last month.

The bank slashed its forecasts for economic growth to 1pc next year, and admitted that inflation will remain stuck at just 0.7pc, a combination that traps large parts of southern Europe in deflationary slump and corrodes debt dynamics. BNP Paribas said eurozone inflation is likely to average 0pc in 2015, after turning negative this month.

“The ECB’s measures are woefully behind the curve,” said Ashoka Mody, a former EU-IMF bailout chief now at the Bruegel think-tank in Brussels.

“For anyone who wants to see it, a debt-deflation cycle is ongoing in the distressed economies. The authorities have very nearly lost control of a process that will become ever harder to manage as it becomes more entrenched,” he said.

Mr Mody said the ECB repeatedly asserts that it will act “if needed” but declines to spell out what that means and why it continues to delay when the inflation level – now 0.3pc - is already so far below target. “Cheap talk is a legitimate policy tool. But talk can also create a cognitive bubble,” he said.

Mr Draghi denied that the ECB is complacent about the deflation risk or that is succumbing to paralysis. “Let me be absolutely clear. We won’t tolerate prolonged deviation from price stability,” he said.

Yet he pleaded for more time to study the effects of the oil price crash and gave a strong hint that there would be no further decisions on monetary stimulus until after the next meeting in January. The governing council discussed possible purchases of every major asset “other than gold” but has not yet agreed to go beyond the current mix of covered bonds and asset-backed securities.

“The credibility of the ECB lies in tatters. It’s now patently clear that Draghi lacks the crucial German support for launching full-blown QE,” said sovereign bond strategist Nicolas Spiro.

Mr Draghi insisted that the bank could in principle ram through the QE decision by majority vote but said he was “still confident” that a package of measures could be designed to keep everybody on board.

Crucially, he revealed that the EBC’s six-strong Executive Board is divided on the bank’s vague pledge to boost the balance sheet back “towards” the levels of early 2012, an implicit €1 trillion commitment.

This almost certainly means that Germany’s board member, Sabine Lautenschläger, has yet to be won over. At a forum last weekend, she decried “activism” for the sake of it and warned that QE would do more harm than good at this point. Purchases of government bonds amount to fiscal transfer and create a “serious incentive problem”, she said.

Mr Draghi’s failure to secure the full assent of his own board is a major headache. The mood is entirely different from events in 2012, when he launched his “do-what-it-takes” plan (OMT) to act as a lender of last resort for Italy and Spain. That plan had the full backing of the (then) German board member and the support of Chancellor Angela Merkel, who preferred ECB action to another traumatic bail-out vote for Club Med debtors in the Bundestag. This time Mr Draghi faces stiff resistance from across the German establishment.

While the ECB Council operates on a basis of one-man, one-vote, there would be a political storm if full-scale QE was forced through by an Italian ECB president at the head of a "Latin bloc" of debtor states against explicit German objections. Such action would be a recruiting trumpet for Germany’s AFD anti-euro party and would endanger German popular consent for monetary union. The scale of such action might also infringe on the Bundestag's budgetary sovereignty, and violate Germany's Basic Law.

Mr Draghi is understandably loathe to take such a hazardous step, forced to bide his time in the hope that Berlin will gradually yield as deflationary forces threaten Germany itself.

This may happen. Data collected by Marchel Alexandrovich, at Jefferies Fixed Income, show that the number of goods in Germany’s price basket in outright deflation jumped from 22.9pc in September to 31.2pc in October.

The ratio is 36.7pc in Italy, 40.9pc in Spain, 41.7pc in Holland, 43.6pc in Portugal, 54.1pc in Slovenia and 85pc in Greece. Japan’s experience in the 1990s showed that the process is very difficult to reverse once the deflationary effects reach 60pc.

“We believe that the euro area faces a much more challenging situation than that of Japan,”said Jacques Cailloux, from Nomura.

Mr Cailloux said EMU deficit rules and the eurozone’s legal structure make it far harder to fight deflation with fiscal stimulus, and the region already faces a more serious jobless crisis than anything suffered by Japan during its long malaise.

The implication is that Euroland risks falling into an almost irreversible trap if the ECB fails to take pre-emptive action immediately.

Πηγή