The Euro Area has experienced economic growth for eight consecutive quarters and the pace of expansion this year is likely to average around 1.6% from 0.9% last year. Most forecasters, including the ECB, expect that pace of growth, of around 0.4% a quarter, to continue into next year and alongside rising oil prices is projected to lead to a pick up in inflation , to 1.1% in 2016 and 1.7% the following year, and as such nearer the target level. Recent developments in the exchange rate and the oil price may prompt a forecast revision, however, and the ECB has just flagged that it may take further policy action in December, contingent upon an updated inflation forecast.
Headline inflation. which had been negative early in 2015, turned positive in the Spring but has weakened again of late, with September recording another negative number (-0.1%). Energy prices fell by 1.7% in the month and are down some 9% on an annual basis, which of itself reduces the overall inflation rate by 1 percentage point. Core inflation is also weak, however; prices rose by just 0.9% if one excludes food and energy while inflation in services, which accounts for over 40% of the index, is just 1.2%.
The current ECB forecast is predicated on a rise in oil prices to an average of $56 a barrel next year, but this now looks too high; the current forward price of Brent implies a figure around $52. Moreover, the ECB expects the euro to average $1.10 , and as such are clearly concerned about the currency’s recent performance, with a 7.5% appreciation against the dollar since the Spring, taking it above $1.13 from below $1.06, and a 6.5% rise in the trade weighted exchange rate. Consequently, the forecast price of oil in euro terms of €51 now looks wrong on two counts, and may be closer to €46 in the December forecast in the absence of a significant fall in the euro on the FX markets.
Engineering such a fall may be difficult in the absence of stronger US data and a tightening of monetary policy by the Fed but the ECB is likely to take some measures. President Draghi took a step in that direction at today’s press conference by opening the possibility of a cut in the rate the ECB pays for overnight deposits from the banking system. The Deposit rate was cut to -0.2% over a year ago and Draghi had indicated that it was at the effective lower bound but that may no longer be the case, judging by his latest remarks.
Apart from a Deposit rate cut the ECB has also indicated that it will use other instruments to ease policy further if deemed necessary. The simplest. and most likely, is an expansion of the current asset purchase scheme , which could take the form of a higher volume of monthly purchases , a broadening of the assets deemed eligible or a prolongation of the time frame of the programme.
It may well be that we are at the effective limits of monetary policy, and further QE may be both ineffective and political troublesome for the ECB, as it carries implications for income distribution. Some council members have talked about the need for non-policy measures and it may well be that the whole fiscal policy debate will be reopened but for now the ECB remains the only game in town.