Inflation dilemma threatens to spoil ECB’s ‘boring’ 2017

18/1/2017

By Claire Jones

German pressure mounts amid questions over central bank strategy

Mario Draghi wanted to become boring in 2017. He may not be so lucky.

As the president of the European Central Bank heads into what he hoped would be a year of steady-as-she-goes decisions — changing neither interest rates nor the bank’s programme of quantitative easing through buying up bonds — critics on both flanks are ready to disturb his tranquillity.

On the one hand, influential voices in Germany, motor of the eurozone, are increasingly concerned by the bank’s loose monetary policies at a time when rising inflation is eroding returns for savers. The ECB could come under growing pressure for further cuts to QE should German inflation persist or climb.

On the other hand, economists disappointed with the decision in December to trim QE fear the bank will destroy the credibility of its central mission — to keep inflation close to 2 per cent — if it succumbs to any pressure to scale back bond purchases.

They say the ECB has become the opposite of boring — which in central banking terms means reacting to economic news in a predictable way. Far from behaving consistently, they believe that Mr Draghi and his colleagues on the bank’s governing council have fundamentally changed tack by signalling they want to stand pat this year.

“Their message until recently was that they were always ready to respond,” says Richard Barwell, an economist at BNP Paribas Investment Partners. “The objectives [now] seem much more modest and their actions a lot less courageous.”

Mr Barwell says the bank looks more like an institution doing enough to avoid deflation than one concerned with hitting its inflation target. “There is a danger you’ll lose credibility: there’s a world of difference between an unconstrained inflation targeter and a constrained deflation avoider,” he says.

Mr Draghi led the bank into a significant change at its last monetary policy meeting in December, sanctioning a scaling back of its monthly QE purchases but extending the duration of the programme. The bank decided that from April it would buy €60bn of bonds a month until the end of this year, down from the current €80bn.

By taking that step, the ECB hoped to remove itself from the political fray in 2017, a crucial national election year for Europe. The Netherlands and France vote in the spring before a poll in the autumn in Germany, where the bank’s interest rate cuts and government bond purchases are notoriously unpopular.

There is no expectation that Thursday’s monetary policy meeting will change borrowing costs or QE. Without a drastic economic deterioration, Mr Draghi also wants to maintain “a steady hand” at this year’s other seven meetings and stick to the package he announced in December.

Price pressures are weaker than the ECB’s target of just under 2 per cent and a more severe bout of inflation is unlikely. Inflation for the region is 1.7 per cent and is expected to come in at below the ECB’s target in 2019, according to current projections.

The pinch point is Germany, where inflation rose from 0.8 per cent in November to 1.7 per cent last month. In an environment of ultra-low interest rates and anti-euro sentiment, the calls for the ECB to stop penalising German savers and raise rates were immediate.

The hawks on the central bank’s governing council, led by Bundesbank president Jens Weidmann, are unlikely to press the case for further cuts to QE immediately. They are more likely to wait until at least March, when a trigger could be a fresh set of ECB forecasts showing a sharper than anticipated recovery in inflation and growth.

On the other side of the policy debate, concerns about the constraints on the ECB have risen following the publication of minutes of its December vote, which signalled the decision to trim QE was made not just on economic grounds but on fears the ECB would run out of bonds to buy.

Economists’ assumptions that the bank could raise the amount of a particular government bond it could purchase were quashed after the minutes said too many legal and reputational risks were at stake.

“The big disappointment in December was the clear evidence of the role technical limitations and political constraints had played in that decision. I get the point — I underestimated the obstacles, but it doesn’t feel consistent with [Mr Draghi’s statement that the ECB would do] ‘whatever it takes’,” says Frederik Ducrozet, economist at Pictet Asset Management.

Addressing political pressure makes sense now but could create a bigger headache in the longer term, Mr Ducrozet says.

“The big challenge will come in June or September, when [the council] will have to decide what to do next year. If core inflation stays low, then I don’t know what they can do next now they admitted to these constraints.”

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