Mario Draghi’s speech in Jackson Hole? A game changer

In his speech in Jackson Hole, Mario Draghi has launched new thinking for a new economic policy in the Euro Area.
His starting point is the analysis of unemployment (major theme this year in Jackson Hole) which has short-term and more structural explanations. He said that in such an environment, monetary and fiscal policies must be coordinated in the short run to support demand and that at a mid-term horizon structural reforms were needed in order to improve competitiveness and growth autonomy (his text is here)

Short term issues
Mario Draghi is clearly worried as the Euro Area can be characterized by its low economic momentum, its high structural unemployment rate and its low inflation rate (0.4% in July)
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The ECB changes the scale of its operations

The ECB has announced measures to stabilize the money market and measures which will bring more liquidity at a longer horizon in order to boost credit growth and a more sustainable growth recovery.
This will keep interest rates at a very low-level for an extended period, at least until the end of 2016. This will have a long-lasting downward effect on the interest rates structure, peripheral countries included. Even with a negative deposit facility rate, I don’t think that the euro exchange rate will drop. The current account surplus of the Euro Area is large and here to stay. That will maintain a strong euro exchange rate.
Targeted operations on credit will transfer credit risks from the banking system to the ECB. But this transfer will be temporary. The length of the operation is limited to four years. This could be a boost for the development of credit but there are still uncertainties on the banks’ willingness to renew a kind of operation that was put in place at the end of 2011 and beginning of 2012. As I mentioned in an earlier post (here), will it be sufficient to exit from a risk of deflation? That’s the question because the inflation rate will not converge to its target before 2017 – 2020. It’s still far in the future.

Measures taken by the ECB
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Inflation in the Euro Area at 0.5% is too low and expectations on the ECB are probably too high

An inflation rate at 0.5% in May is clearly too low. But with contributions from energy and food sectors at 0, it means that this low inflation rate has nothing to do with commodities. It’s related to internal weakness of the Euro Area. Some specific factors (Easter,…)can be put perceived as an explanation but it is just an impact of +/-0.1% and does not explain the very low trend of the inflation rate. Moreover, due to uncertainty in measures, at 0.5% the probability of already being in deflation is not null.

There are three plus one factors that can explain this situation Continue reading

Low Inflation, Deflation and Economic Impact

Indebtedness and deflation do not go well together.
I spoke about this issue a few weeks ago (see here in French) and Paul Krugman made a post on his blog this week-end (see here). Lars Svensson, speaking on Sweden, has interesting arguments on this issue. They can change our view on ECB strategy.

Indebtedness and deflation
The issue is quite simple: when there is deflation, the real value of indebtedness increases, leading to new arbitrages in households’ budget.
The higher the indebtedness, the stronger are the impact and the arbitrages. Moreover, deflation periods are usually associated with low or negative wages growth. In other words, in this context, households have to reduce their expenditures in goods and services in order to fulfill their financial liabilities. Continue reading

The ECB must act to break deflation expectations

Will the ECB take into account the risk of deflation that each investor has in mind today? It is on this question that the ECB is expected at its meeting this day.
So far, the central bank has not wanted to go in this game, indicating that inflation would remain low for a long time and the deflation risk would keep very low. This is about the last Draghi press conference. However this is only moderately reassuring because the expected inflation in 2016 is only 1.5 % well below the 2% target. In addition, despite the reassuring figures projections of the ECB, it cannot be excluded that, in the meantime, price change could tangent deflation.
In addition, a strong call from Draghi is desired because many statements caused confusion on the perception that may have European central bankers on this issue. On this point, everyone has retained what Jens Weidmann, the head of the Bundesbank, said on the risk of deflation and the possibility of dealing with it with a sort of QE .

What analysis can be done of the risk of deflation?
For me there are three elements to consider Continue reading

Low inflation rate in the Euro Area – A complex situation

The inflation rate in the Euro Area was at 0.5% in March. Except during the period with high volatility in oil price, in 2008/2009, the yearly change of the consumption price index has not been so low.
The chart below shows statistics of the inflation rate since its inception. I’ve also shown the core inflation rate which also close to its historical low.
EA-2014-March-InflationOf course there is a fear of deflation but that’s not as simple as that.
Two remarks: Continue reading

ECB: Monetary Policy and the Euro Area

The post is available in pdf format here ECB-MonetaryPolicy

The ECB is in a corner. Its rates are close to 0% with the refi rate at 0.25%. Lowering it at 0.1% would not change the picture and is probably not the recipe to bring the Euro exchange rate lower. In November when the refi rate was cut from 0.5% to 0.25%, the impact on the euro/dollar parity was hardly seen. The deposit facility rate is at 0%. Taking it lower would bring it in negative territory. Is such a move, which could destabilize banks, reasonable just before the Asset Quality Review? Probably not.
So the ECB could increase its liquidity to supplement the Zero Lower Bound problem as it has been done in other central banks. But there are questions on the kind of assets it can buy: Not public debt, not banking assets as during the LTRO because 2014 is the year that will settle the Banking Union. And now the OMT is at risk after the German constitutional court decision.
All this is problematic as deflation threats. The adjustment mode within the Euro Area leads to reduce costs and to follow the global economic cycle that is picking up. The risk of deflation is not null but what are the tools the ECB needs to fight it? Continue reading