ECB View: Failure to meet inflation target has hurt inflation credibility – Anchoring inflation expectations at around target is crucial to any central bank meeting its inflation objective. If companies and employees believe that inflation will be at the central bank’s inflation goal over the medium term despite short-term fluctuations, the central bank has a much bigger chance of success. This is because the inflation goal will be at the core of price and wage-setting behaviour, making that inflation outcome more likely. So a central bank’s inflation credibility is key. At the last ECB Governing Council meeting the ECB announced new projections through to 2021, which together with history, suggest that 2021 will be the ninth calendar year in succession that the central bank will fail to meet is inflation objection in terms of the annual year average. So there would be a rationale for economic actors to expect a lower inflation outcome in making their decisions, hence perpetuating lower inflation. ECB President Mario Draghi sounded unconcerned about this risk saying that the probability ‘of a de-anchoring of inflation expectations (is) very low in our assessment’. However, the Governor of the central bank of Finland, Olli Rehn, sounded more worried in remarks at the end of last week. Bloomberg News quoted him as saying that ‘ inflation expectations remain at historically low levels, persisting below the ECB’s goal for so long that they’ve turned into a self-fulfilling prophecy’. He went on to assert that this was a reason for a strategy review.
So are inflation expectations dislodged? There is clearly evidence of this happening. Between 2005 and 2013, the 5y5y inflation swap averaged 2.4%. Since 2014, the same measure has averaged 1.7%. These levels do not necessarily correspond to the actual inflation rate, but we find the change between the two periods rather striking. This would also be consistent with actual inflation developments. Headline inflation averaged 2.1% between 1999 and 2012, but only 1.1% between 2013 and 2021 (using ECB projections for 2019 to 2021). Meanwhile, although the ECB’s panel of professional forecasters see inflation at 1.8% in five years’ time (which is close to the inflation goal of 1.9%), they do have their doubts. Since 2013Q3, they have rated the chances of inflation being below target as being significantly greater than being above target.
So what does all this mean for the ECB? Our base case is that the central bank will keep interest rates on hold until the end of next year and will maintain re-investments for a year after that. However, there is a rising chance in our view that the central bank will need to do more if it is serious about meeting its inflation goal in a sustainable fashion and breaking the vicious cycle between low inflation expectations and low actual inflation outcomes. This would be made more likely if the governments that have room for manoeuver do not respond to weaker economic growth by stepping up fiscal stimulus. The most likely policy tool is a restart of net purchases under a broad asset purchase programme. We will discuss the complexities around such a move in more detail in upcoming publications.
Of course an obvious criticism of QE is that the above narrative proves it did not work, so what would the point of re-starting it? However, this does not take the counterfactual into account. An ECB research note published today (see here) concludes that the central bank’s unconventional policies have boosted (will boost) inflation and economic growth each by 1.9 percentage points between 2016 and 2020. One can of course argue about the precise numbers produced by model estimates, but the view that inflation would be even lower without these policies seems a reasonable one. (Nick Kounis)
FOMC Preview: Tightening bias in dots could disappoint markets – We expect the FOMC to keep interest rates on hold this Wednesday, and to announce an end to the balance sheet runoff in September, though there is a risk the announcement could slip to a subsequent meeting (see below for details). We expect Chair Powell to strike a somewhat dovish tone in his press conference, noting the continued global economic uncertainty given the lack of a stabilisation in the global industrial sector. However, we also expect him to acknowledge the substantial improvement in domestic financial conditions since late last year, and signs of resilience in domestic demand, such as the rebound in consumer confidence. At the same time, while we expect a shift lower in the dots rate hike projections to show just one rate hike in 2019, this might disappoint financial markets, which now price in around 6bp of rate cuts by year end. We continue to think the Fed is done with rate hikes, but that it will maintain a modest tightening bias in its rate hike projections for as long as the economic outlook remains broadly positive.
Balance sheet runoff to end by Q4 at the latest – In a well-telegraphed move, the Fed is likely to announce an end to its ‘quantitative tightening’ balance sheet unwind, likely in September. Officials have already signalled that the runoff will be done by year-end, and we think it could come even sooner. The NY Fed’s primary dealer survey suggests expectations that reserves will stabilise at around USD1trn. Given the Fed’s preference for a buffer over reserve demand, we think the Fed will opt for a stabilisation closer to USD1.2trn. This would imply a terminal balance sheet size of USD3.7trn, vs USD3.9trn currently, and would be consistent with a September end to the runoff. It is possible that the Fed opts to ‘taper’ the end of the runoff in the interest of market stability, as it did the end of asset purchases and at the start of the runoff. In this case, tapering of the current USD50bn per month runoff could start as soon as June, and if purchases continue at, say, USD25bn per month, the runoff would end in Q4 at a similar terminal level of USD1.2trn excess reserves/USD3.7trn balance sheet. (Bill Diviney)