Economic growth in the euro area (EA) has been trundling along at 0.4% per quarter, which is probably above the zone’s potential rate but has not been strong enough to put much upward pressure on prices; core inflation is likely to average under 1% in 2015 and although some acceleration is generally expected over the next few years it is forecast to be modest. The ECB’s inflation target is set in terms of headline inflation, which is currently lower still, at around zero, and again that is expected to pick up, reflecting the unwinding of the recent falls in commodity prices, but few if any forecast a rebound to 2% or above by end-2017.
Low or zero inflation is supportive of real household incomes given the modest pace of wage growth ( 1.9% in the EA in q2 and 1.8% in Ireland) but the ECB is concerned about a prolonged period of below-target inflation, not least in terms of its own credibility. A more fundamental reason is that the real rate of interest (the nominal rate minus expected inflation) rises if expected inflation falls, which all else equal will dampen investment spending in the economy.
Those concerns have prompted the Governing Council to contemplate further monetary easing, including additional non-standard measures such as an expansion of QE. The latter has helped to boost asset prices in the EA and lowered corporate and bond yields, according to the ECB, but it is less clear what impact that has on inflation- the effect on demand in the economy may not be large enough to put significant upward pressure on prices. QE is also deemed to weaken the currency and the euro certainly fell sharply in the early months of 2015, declining by 11% in effective terms to mid-April. According to the ECB’s models, a 5% depreciation could boost inflation by up to 0.5 percentage points so a currency depreciation would seem to have the biggest impact on prices.
The euro reversed course over the summer months, however, rising by 7% in the four months to end-August , but has started to fall again and is currently about 7% below its value a year ago, albeit still 2.5% above its April lows. This also reflects the expectation of rising rates in the US but the ECB may well seek to precipitate a much steeper fall in the effective exchange rate.
To that end the ECB has flagged a possible cut in its Deposit rate, which for over a year has been at -0.2%. Despite that, deposits at the ECB, which had been very low at the beginning of the year, have risen strongly of late and currently stand at €187bn i.e. banks would prefer to pay to leave cash at the ECB rather than lend it to their peers. Draghi had previously indicated that rates had reached the effective lower bound but that may be reassessed, not least because the deposit rate is at -0.75% in Switzerland and Sweden. Consequently, any Deposit rate cut in early December may be larger than the modest change generally expected and a rate of -0.5% could be on the cards, which would also increase the universe of bonds eligible for QE. Similarly, the refinancing rate could also move to zero or even marginally negative (the Swedish reo rate is -0.35%) if the ECB wants to surprise the markets and engineer a more substantial fall in the exchange rate.