With inflation rates in the eurozone remaining substantially below the European Central Bank’s (ECB) target of less than 2%, the governing council seems likely to vote for an increase in the size of the quantitative easing (QE) program in the following weeks. As a result, the euro could see further downward movement, which will likely have economic and political side effects — especially if US interest rates rise as expected.
The latest figures for the euro area as a whole reveal that the harmonized consumer price index fell by 0.1% year-over-year in September 2015. After five months of slowly rising consumer prices (growth rates were between 0.1% and 0.4% April-August), inflation rates are back in negative territory, despite the ECB’s €60-billion-a-month QE scheme. This has raised the question of whether the ECB should increase the size of its bond purchase or if waiting for commodity prices to rise could be the better option.
Arguably, most of the deflationary pressures in the region stem from ultralow commodity prices. Central banks in general and the ECB in particular do not normally react to fluctuating energy prices as they are too volatile to control. The time lag of monetary policy is too long to tackle energy-price-induced inflation. However, in the current case, even if energy prices are taken aside (dubbed “core inflation”), the ECB fails to deliver on the 2% target. Core inflation stood at a mere 0.9% in September.
So while a sizable share of the current low inflation rates in the eurozone is caused by low energy prices, the high unemployment rate and the still sluggish pace of the economic recovery are also contributing. The QE scheme has helped in this respect as it had a positive (albeit a small) effect on bank lending to nonfinancial corporations, which raised investment activity.
Unemployment in the common currency area has also come down from 11.3% in January to a still high 11% in August, and, most importantly, the euro has lost more than 10% against the US dollar and 5.6% against the British pound between October 2014 and October 2015. This depreciation led to a price increase of imported goods (which helped inflation rates) and increased the price competitiveness of eurozone exporters.
Looking ahead, the ECB will likely increase the size of its QE plan and extend its duration beyond the initial September 2016 deadline. The ECB’s current program is four times smaller than the UK’s, five times less than the US’s previous QE programs, and 13 times smaller than Japan’s.
Indeed, recent remarks by ECB Vice President Vitor Constancio indicate that such a move is in the cards, despite opposition to the measure within the ECB’s governing council. With a single bullet, the ECB could boost the price competitiveness of exporters, push inflation upwards, and remove the upward pressure that has pushed on the euro for several months now. The euro appreciated against the dollar and the pound in the last six months, compared with a steep drop in the prior six months.
An increase in QE will come with a price: Germany’s powerful central bank would have to be outvoted in the council again, as it opposes QE. Most importantly, the domestic bond market (which is much smaller than that of the UK, the US, and Japan) might experience asset bubbles.
However, given that the ECB is failing to deliver on its only task — to keep inflation at 2% — and has used all of its other available tools already, there are no other options.
Having previously worked for the European Parliament in Brussels, Markus Kuger joined D&B’s office in Marlow/United Kingdom in June 2010. In his role as Senior Economist in D&B Macro Market/Country Insight Products, he is writing about his home country Germany as well as the UK, France, the Netherlands, and Poland.
Photo courtesy European Central Bank.