During the last few months, inflation has been a trending topic, especially for economies such as the eurozone, where inflation has been running steadily below the explicit objective of two percent. The ECB (European Central Bank) has expressed its concern, especially during its last monetary policy decision. In later speeches, Draghi has explicitly stated the three main events that could trigger a move from the ECB.
"With our forward guidance, we aim to give guidance on the expected level of future interest rates, and to remove uncertainty about that level by strengthening communication on our reaction function. We have also further simplified our reaction function by laying out some contingencies that would warrant a monetary policy reaction. These are, first, an unwarranted tightening of monetary policy stance (from developments in short-term money markets, global bond markets or foreign exchange markets) that could be tackled through more conventional measures. Second, a further impairment in the transmission of our stance, in particular via the bank lending channel, for which a targeted LTRO or an ABS purchase programme might be the right response. Third, a worsening of the medium-term outlook for inflation, which would warrant a more broad-based asset purchase programme. The Governing Council is committed – unanimously – to using both unconventional and conventional instruments to deal effectively with the risks of a too prolonged period of low inflation."
In this post, I just want to focus on the third event, which is related to a worsening of medium term outlook for inflation, that could be related, at some point, with how well anchored inflation expectations are in the Eurozone.
The ECB research staff just released a paper in which they compare how well anchored inflation expectations are in the eurozone compared to the US, and they conclude that "Overall, inflation expectations are anchored somewhat more firmly in the euro area than in the United States."
I am just curious about this conclusions and would like to dig further into their arguments.
The paper states:
"One method to assess the degree of anchoring is by analysing the reactions of medium- to longer-term inflation expectations when new information on inflation and economic indicators is brought to the market. If they are reacting strongly to releases of conjunctural information, it suggests that economic agents do not expect the central bank to react credibly and fast to changing economic conditions. Similarly, when medium- to longer-term inflation expectations are not influenced by economic news releases, it indicates that market participants are confident that monetary policy will be adjusted to counter any risk to the inflation objective of the central bank (see, e.g., Clarida, Gal´ı, and Gertler (2000)).
Theoretically and intuitively, this make sense, but the reaction function of both Central Banks has been very different, and it has been clear during the last years that the Federal Reserve has been way more proactive than the ECB, wich has maybe a more complex problem (because of the differences in the monetary transmission channels). Furthermore, the ECB does not enjoy the same flexibility as the FED in order to act in a timely manner to counteract shocks that could affect inflation expectations.
Maybe the ECB is trying to justify its lack of reaction, but what is true, is that even if it is not obvious that deflation is a real threat in the immediate future, on my perspective, they are overconfident about their view. If they are wrong and deflation becomes real, that could be very costly.
Regarding markets, it is very probable that the market is going to test ECB patience and will drive the EUR to above 1.40 toward the 1.45 mark in the next few months. Let see if Draghi wins the hand of poker again.
