The exchange rate and oil price, not growth, key for ECB QE exit

The consensus was badly wrong on the euro zone last year, significantly underestimating the pace of economic growth and the single currency’s appreciation against the US dollar. This year, growth is expected to remain strong and the euro is generally forecast to appreciate modestly, while many believe the ECB will cease its net asset purchase programme by year-end, with a strong majority of analysts also expecting that to be followed by a rate rise in 2019.

The ECB staff forecast also projects above-trend growth for the next three years, resulting in a steadty decline in the unemployment rate to an average of 7.3% in 2020, from over 9% last year. Yet inflation is still forecast to be below target in 2020, at 1.7%, despite years of QE and negative interest rates. Indeed, the December forecast actually revised down the Bank’s projections for core inflation ( the headline rate excluding food and energy)  by 0.2 percentage points over the next two years.

In fact the ECB has significantly changed its forecast relationship between growth and inflation, as indeed have many Central banks. In their macro models, stronger GDP growth leads to lower unemployment  which in turn boosts wage inflation and ultimately price inflation via higher costs for firms, which are passed on to consumers. But, as is now well recognised,the relationship between unemployment and wage inflation has changed and the ECB is now adjusting its forecasts to reflect that fact. Two years ago, for example, an unemployment rate of 10% was expected to generate a 2.1% rise in wages but in the latest forecast wage inflation in 2019 is projected to be below 2% despite an unemployment rate as low as 7.8%.

So stronger growth. per se, is no longer  a sufficient condition for a meaningful acceleration in price inflation in the Staff forecasts, with the path of inflation strongly influenced by the exchange rate ( with a quick pass through to import prices ) and the oil price ( energy accounts for about 10% of the CPI). Oil prices in the current forecast are expected to decline modestly over the next few years (based on the futures market) to $57 a barrel by 2020, but if they fell further, to say $50, annual inflation would be 0.2% lower in 2019 and 2020. On the exchange rate, the euro/dollar is forecast to be broadly unchanged at $1.17 but if it appreciated to , say,  $1.35 over the next few years it would reduce the forecast CPI  in 2020 by  0.6 percentage points.

The ECB’s forecasts could well be wrong, of course, and  inflation may pick up by more than expected but they highlight the risk of what could be a huge policy dilemma later this year.The Bank probably wants to call a halt to asset purchases for a variety of reasons but what if the euro does indeed appreciate and oil prices decline, so leading to lower forecast inflation? Awkward for a Bank that has argued that QE is crucial in getting inflation back up to target.