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A worrying drop in inflation expectations
Having already announced substantial measures in June, the Governing Council of the European Central Bank (ECB) reacted decisively yet again when it met on 4 September. It announced not only a further 10 basis-point cut in policy rates but also a programme to purchase asset-backed securities (ABS - the principle of ABS and their potential role).
The critical role of medium-term inflation expectations
The main reason the ECB has stepped up its actions is that medium-term inflation expectations have dropped significantly during the summer. One of the most closely watched indicators is a proxy for the expected five-year inflation rate, five years forward, i.e. for the inflation rate expected by the market for the period 2019-2024 (more precisely, the inflation rate for this period that would be consistent with the current prices of traded financial instruments). This indicator has dropped significantly since the beginning of the summer, dipping below the 2% threshold.
Before ECB President Mario Draghi made his speech at Jackson Hole on 22 August, the central bank had always insisted that although actual inflation had sunk to all-time lows in recent months, medium-term expectations had remained stable around 2%. The recent drop in expectations is worrying because it suggests markets are beginning to doubt whether the ECB can achieve an inflation rate of 2% in the medium term.
The danger is that this process could become self-fulfilling. Once economic agents expect inflation to remain very low for an extended period of time, these expectations will be reflected in the negotiation of numerous contracts and hence in price formation. In this case, there would also be a greater risk of tipping into outright deflation should there be another negative shock.
So what is the likely effect of the measures announced by the ECB and will they be sufficient to return to inflation levels around 2% in the medium term?
Boosting credit and investment
If these measures proved to be insufficient, then the ECB would find itself in an increasingly difficult position. As Mario Draghi has pointed out, policy rates seem to have reached their “lower bound”. The last weapon in the ECB's arsenal would then seem to be a large-scale bond buying programme.
BGL BNP Paribas
Published on paperjam.lu (in French) on 11 September 2014