WHY THE ECB IS LIKELY TO BE FORCED TO EASE MONETARY POLICY AGAIN AS INFLATION DECELERATES

By David J. Powell, author of The Trader’s Guide to the Euro Area

A deceleration of inflation is likely to eventually force the European Central Bank to ease monetary conditions again and maintain loose policy for the foreseeable future.

Traders Guide to the Euro Area

Traders Guide to the Euro Area

Inflation in the euro area is trending downward. The headline HICP reading fell to 0.7 percent year over year in October from 1.1 percent in September. It has declined from a recent peak of 3 percent in November 2011.

The latest inflation data revealed the Governing Council is significantly undershooting its target. The ECB “aims to maintain inflation rates below, but close to, 2 percent over the medium term.”

Inflation has also been weaker than forecast by the staff economists. They projected in September an HICP inflation reading of 1.5 percent for 2013 and 1.3 percent for 2014.
Updated forecasts will be published in December. Estimates for GDP and inflation produced jointly by “experts from the ECB and from the euro area national central banks” are released biannually in June and in December. The ECB staff “complements” those projections with updates in March and in September.

The core reading paints an equally grim picture. It declined to 0.8 percent year over year in October from 1 percent in September. It peaked most recently in July 2012 at 1.7 percent. The core figure measures inflation inertia.

Lending data give reason for concern as well. Loans to non-financial corporations, adjusted for sales and securitization, fell 2.7 percent year over year in September versus minus 2.9 percent in August. The equivalent figure for households stood at 0.3 percent year over year, unchanged from the previous month.

That has caused the ECB to veer from the aims of the second pillar of its monetary-policy strategy as well. The three-month average of M3 money supply growth fell to 2.2 percent year over year in September from 2.3 percent in August. Those figures compare with the central bank’s “reference rate” of 4.5 percent.

Slack in the economy is likely to continue weighing on inflation. The unemployment rate remained at a record high of 12.2 percent in September. The OECD estimates the non-accelerating inflation rate of unemployment for the region to be 9.8 percent.

The recovery appears too weak to counter that problem. The level of GDP is still about 3 percent below its pre-crisis peak.

The euro-area economy emerged from recession during the second quarter of this year. It grew 0.3 percent quarter over quarter. The increase in total output followed six consecutive quarters of contraction. The year-over-year figure stood at minus 0.6 percent

A Taylor Rule model suggests easing is required to nurture the recovery. The monetary policy tool, based on coefficients estimated by the Federal Reserve Bank of San Francisco, suggests the one-week refinancing rate should be reduced to minus 0.25 percent. That compares with the present level of 0.25 percent. The signal is the result of low core inflation and high unemployment.

The hawks on the Governing Council have latched on to signs of recovery to oppose additional easing. The two best coincident indicators of GDP growth – the PMI surveys and industrial production – have provided them with some support.

The composite PMI survey suggests the expansion continued during the third quarter. The headline reading stood above 50 during July, August and September. It also remained above that threshold during the first month of the fourth quarter. The PMI surveys are the timeliest indicators of the present state of the economy and among the first monthly economic indicators released.

David Powell

David Powell

Industrial production data paints a similar picture. The index rose 1 percent month over month in September, though the year-over-rate registered minus 2.1 percent.

Industrial production provides a good indicator of overall GDP. A regression of industrial production growth on a quarter-over-quarter basis on GDP in the same form suggests that it explains 64 percent of the variation in overall output using data from the first quarter of 1995 to the second quarter of 2013.

The German Ifo survey – a leading indicator – also provides reason for optimism. The expectations component rose to 103.6 in October from a recent trough of 93.3 in September 2012.

The Ifo survey has been a good indicator of the euro-area economy as a whole, though the survey is only based on feedback from companies in Germany, the continent’s largest economy. The quarterly average of the expectations component of the survey tends to lead the year-over-year rate-of-change of euro-area GDP by three to six months. When the publishing lag is included, the lead is about four to seven months.

The German ZEW survey is sending a similar signal. The expectations component rose to 52.8 in October – the highest level since April 2010 – from a recent trough of minus 55.2 in November 2011.

The survey has also been a good indicator of the euro-area economy as a whole, though it is only based on feedback, with a few exceptions, from financial analysts in Germany. The quarterly average of the expectations component of the ZEW survey is most highly correlated with year-over-year euro-area GDP growth with a lead of three quarters.

Real M1 money supply growth is also signaling a recovery. The latest year-over-year figure – for the month of September – stood at 5.5 percent. That compares with a recent trough of minus 1.4 percent in June 2011. Real M1 money supply growth is the indicator of economic growth that provides the longest lead. It leads GDP growth by about four quarters.

The system of “consensus” building used by the Governing Council has allowed dissenters to squash the will of the majority. For example, most of the body’s members wanted to reduce the main policy rate of the ECB in December 2012 and the move was reportedly blocked by President Mario Draghi and Executive Board members Benoit Coeure and Joerg Asmussen as well as Bundesbank President Jens Weidmann.

The system still appears to allow the president to impose his will on the Governing Council by only selectively proposing a vote on matters of monetary policy. For example, in August 2012, Draghi appeared to suggest that he would overcome the opposition of Weidmann to the purchase of government bonds by having the latter outvoted.

Draghi appears to have repeated that act at the meeting in November. He will probably find himself in a similar position in the months – and possibly even years – to come.

About the Author:
David J. Powell is the author of The Trader’s Guide to the Euro Area: Economic Indicators, the ECB and the Euro Crisis. He is an economist at Bloomberg LP in London where he focuses on euro-area economics and currencies. Previously, he worked at Bank of America – Merrill Lynch as a currency strategist. He holds a master’s degree from the London School of Economics and Political Science, where he wrote his dissertation on the creation of monetary union in Europe, and a bachelor’s degree from New York University.

The Trader’s Guide to the Euro Area: Economic Indicators, the ECB and the Euro Crisis is published by Bloomberg, an imprint of Wiley, priced £29.99.

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