Blog Post

Inflation expectations and global risks: the need for ECB action

The ECB will have its next monetary decision meeting on Thursday. Instead of following politically motivated statements that complain about low nominal rates, the ECB needs to focus on its mandate: price stability, defined as inflation rates close to but below 2% in the medium-run. So what do data on inflation dynamics and on the risks for euro area inflation tell us?

By: Date: October 21, 2015 Topic: European Macroeconomics & Governance

Let’s start from the observable facts. Euro area inflation has been falling since 2011Q4 and while there was a short pick-up in early 2015, it has fallen again recently. The recent fall, however, is less clearly visible in core inflation rates. Core inflation, i.e. inflation rates excluding prices for commodities that have recently fallen, has been rather stable at slightly below 1% since mid-2013. Observable inflation rates therefore speak for an easing bias rather than a tightening bias in monetary policy.

Figure 1: Headline and core inflation in the euro area

GW_21_10_15_1

Source: Datastream

Second, the price stability mandate is, of course, not about current inflation rates but rather medium-term expected inflation rates. A number of worrying indicators appear. Market-based inflation expectations have fallen since the summer. While in July markets were still expecting inflation to be at 1% in 2017, the expectation is now only slightly above 0.5%.

Figure 2: Market-based inflation expectations


GW_21_10_15_2

Source: Datastream
Notes: Market-based inflation expectations are based on one to ten year inflation-linked swaps.

The ECB itself got its inflation forecasts often wrong in the past. The figure shows that compared to actual inflation, the ECB’s own forecasts tended to show an increase in inflation rates. In March the ECB was still forecasting inflation to be at 1.5% in 2016 and this number has already been revised downward to 1.1%.

Figure 3: Actual inflation vs ECB forecasts

GW_21_10_15_3

Source: Datastream, ECB Staff Macroeconomic Projections

The survey of professional forecasters (SPF) does not yet show a decline in inflation expectations but it also failed previously to forecast the decline in inflation rates (see chart). Moreover, the two-year-ahead inflation forecast suggests an inflation rate of only 1.5%. Again, this number would certainly speak against a tightening of monetary policy.

Figure 4: Inflation vs what was forecast

GW_21_10_15_4

Source: Datastream

Third, the ECB should learn from past mistakes and shift towards more active risk management. The ECB should end denying the risk of undershooting inflation expectations. True, some of the reasons for lower than expected inflation rates were exogenous factors such as a decline in commodity and oil prices. However, taking the numbers shown above together shows a clear picture of strong deflationary tendencies at work in the euro area. This is a major risk for policy making in the euro area. The lower inflation expectations are, the higher will be the real interest rate and the more difficult it will be for the ECB to prevent further deflationary tendencies. With constrained fiscal policies, the euro area may end up in a low-inflation trap from which it will not be able to escape. The consequences for debt sustainability and delayed macroeconomic adjustment have been discussed compellingly and at length. Conversely, the risk of overshooting the 2% inflation target is not only very low. It is also a risk that can far more easily be managed should it materialize by simply changing interest rates. The case for more active policy to prevent undershooting of inflation rates is therefore compelling.

Fourth, beyond the inherent domestic deflationary tendencies that risk undermining the ECB’s goal, also the global economy faces a number of important risk. Most importantly, there is uncertainty about China. The US Federal Reserve has just delayed a rate increase, and one of the main reasons for this delay was fears about the US economy because of the economic situation in China (as was clearly pronounced by New York Federal Reserve President William C Dudley at an event at Brookings). One can debate endlessly whether or not the Chinese political system will manage to engineer a soft landing of China’s economy. But unless we are a 100% certain that China will economic policy should manage that risk. We have shown before that a sneeze of China has implications for Europe’s stock markets through simple trade channel effects. The ECB should therefore follow the lead of the Fed and carefully consider the risk China poses to fulfilling its price stability mandate.

The ECB, as an independent monetary authority, should be conscious of the risks that failing to fulfil its mandate pose. It should accept that inflation expectations have deteriorated and core inflation remains stubbornly below 1% while the global economy faces a number of risks that could have effects on the euro area.

At the very least, the ECB should continue its ongoing QE programme and clearly dispel doubts that it could bow to political pressures and end its programme prematurely. The ECB was right to expand its list of assets eligible for purchases further after its decision to start sovereign QE in January. A longer list would allow increasing or lengthening the purchase programme. In fact, the ECB could even consider dropping the 25% purchase limit on sovereign bonds with AAA rating. The purchase limit is a sensible measure on bonds with CACs to prevent the ECB from having a blocking vote in debt restructuring decisions. But it would be wrong to constrain QE because of this for bonds with very low risks. An announcement by the ECB to use this option and extend purchases into 2017 would be a strong message that the governing council is serious about risk management. Adding a small-scale programme to support the corporate bond market would be another option to consider. Governments, in turn, should focus on their task of reforming euro area economies so that new investment opportunities arise.

 


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read about event

Upcoming Event

Sep
16
08:30

Climate change and the role of central banks

What connections exist between central banks and climate change, and what are the resulting implications?

Speakers: Emanuele Campiglio, Paul Hiebert, Pierre Monnin, Kjell G. Nyborg, Luiz Awazu Pereira da Silva, Mario Quagliariello, Mattia Romani, Paweł Samecki and Dirk Schoenmaker Topic: Energy & Climate, European Macroeconomics & Governance Location: Narodowy Bank Polski, Świętokrzyska 11/21, 00-919 Warsaw
Read article More on this topic More by this author

External Publication

La Banca centrale europea

This external publication delves into the new responsibility given to the European Central Bank: supervision on banks in the euro-area. It tells its history and illustrates its functions, structure and responsibilities and the exceptional answers to respond to the "perfect storm" of the crisis.

By: Francesco Papadia Topic: European Macroeconomics & Governance Date: July 31, 2019
Read article More on this topic More by this author

Blog Post

Croatia’s path into the banking union

Croatia seems a suitable candidate for euro area accession: there is a tight peg to the euro, high public debt is coming down, and the banking sector is already dominated by euro area banks. But the Eurogroup has rightly targeted reforms of the state’s role in the economy as a precondition for participation in ERM II and the banking union. None of the announced reform plans are new or easily concluded within the timeframe that has now been agreed.

By: Alexander Lehmann Topic: European Macroeconomics & Governance Date: July 18, 2019
Read article More on this topic

Blog Post

‘Lo spread’: The collateral damage of Italy’s confrontation with the EU

The authors assess whether the European Commission's actions towards Italy since September 2018 have had a visible impact on the spread between Italian sovereign-bond yields and those of Germany, and particularly whether the Commission’s warnings have acted as a ‘signalling device’ for bond-market participants that it might be difficult for Italy to obtain the support of the ESM or the ECB’s OMT programme if needed.

By: Grégory Claeys and Jan Mazza Topic: European Macroeconomics & Governance Date: July 8, 2019
Read article More on this topic More by this author

Podcast

Podcast

Director's Cut: Priorities for the new ECB president

In this Director's Cut of 'The Sound of Economics', Guntram Wolff talks to two of the authors of Bruegel's memo to the new ECB president, Maria Demertzis and Grégory Claeys, to specify the most important issues at the beginning of this eight-year cycle and to clarify the parameters within which the new incumbent will have to work.

By: The Sound of Economics Topic: European Macroeconomics & Governance Date: July 4, 2019
Read article Download PDF More on this topic

Policy Brief

Preparing for uncertainty

Memo to the president of the European Central Bank. Grégory Claeys, Maria Demertzis and Francesco Papadia present the challenges that the next ECB president will face during the upcoming mandate, reinventing monetary policy in a system riddled with uncertainties.

By: Grégory Claeys, Maria Demertzis and Francesco Papadia Topic: European Macroeconomics & Governance Date: July 3, 2019
Read article More on this topic More by this author

Blog Post

The breakdown of the covered interest rate parity condition

A textbook condition of international finance breaks down. Economic research identifies the interplay between divergent monetary policies and new financial regulation as the source of the puzzle, and generates concerns about unintended consequences for financing conditions and financial stability.

By: Konstantinos Efstathiou Topic: Finance & Financial Regulation Date: July 1, 2019
Read article More on this topic More by this author

Podcast

Podcast

Director's Cut: ECB monetary policy decisions deconstructed

In this Director’s Cut, Bruegel’s Grégory Claeys and Maria Demertzis take a deeper look at whether the monetary policy decisions made by the ECB over the past three presidential eras arrived by consensus, by unanimity or by majority votes of the governing council.

By: The Sound of Economics Topic: European Macroeconomics & Governance Date: June 27, 2019
Read article More on this topic

Blog Post

The evolution of the ECB governing council's decision-making

Before it is decided who will chair the governing council for the next eight years, the authors look back and examine precisely how decisions have been taken since the ECB was created – by unanimity, by majority, or by consensus.

By: Grégory Claeys and Tanja Linta Topic: European Macroeconomics & Governance Date: June 27, 2019
Read about event More on this topic

Past Event

Past Event

Sound at last? Assessing a decade of financial regulation

What has changed since the financial crisis of 2008 that makes the financial system sound at last? Is regulatory reform going in the right direction? Has it run its course? 

Speakers: Patrick Bolton, Rebecca Christie, Maria Demertzis, Mathias Dewatripont and Xavier Vives Topic: Finance & Financial Regulation Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: June 20, 2019
Read about event More on this topic

Past Event

Past Event

What reforms for Europe's Monetary Union: a view from Spain

How is a successful European Monetary Union still possible in today's ever-shifting political landscape? What reforms need to occur in order to guarantee success of cohesive policies?

Speakers: Fernando Fernández, José Carlos García de Quevedo, Gabriele Giudice, Inês Goncalves Raposo, Javier Méndez Llera and Isabel Riaño Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: June 19, 2019
Read article More on this topic More by this author

Blog Post

The inverted yield curve

Longer-term yields falling below shorter-term yields have historically preceded recessions. Last week, the US 10-year yield was 21 basis points below the 3-month yield, a feat last seen during the summer of 2007. Is the current yield curve a trustworthy barometer for future growth?

By: Inês Goncalves Raposo Topic: Global Economics & Governance Date: June 11, 2019
Load more posts