COLUMN-Deflation alarm may jar ECB into keeping pace with Fed :Mike Dolan
(The opinions expressed here are those of the author, a columnist for Reuters.)
By Mike Dolan
LONDON, Sept 2 (Reuters) – With deflation alarms ringing again at the European Central Bank, August’s price shock piles pressure on it to ape the Federal Reserve’s looser inflation goal and possibly earmark even more easing down the line.
If the ECB does nothing, currency markets pushing the euro to its highest level in more than two years against the dollar may cause another headache for the bloc’s policymakers by stoking deflation fears as sovereign and private debts soar.
Although economic indicators have been erratic at best during the COVID-19 pandemic, Tuesday’s surprise showing the first headline contraction of euro zone consumer prices since 2016 was sobering, not least for financial markets.
Annual euro zone inflation fell by 0.2% in August, confounding forecasts for a modest gain. The ECB’s favored measure of annual ‘core’ inflation, which removes volatile energy and unprocessed food, more than halved to just 0.6%.
Yet, instead of taking this as a trigger for further ECB easing measures as soon as its policy meeting next week, the euro edged higher against an ailing dollar, topping $1.20 for the first time in more than two years.
ECB board member Isabel Schnabel, in an interview with Reuters on Monday, played down the euro’s 4% trade-weighted rise this year, adding that she was “not worrying too much about exchange rate developments”.
What’s more, Schnabel said dollar losses tend to lift global trade and growth and this could compensate euro zone firms.
APEING THE FED?
But the main reason for the dollar’s latest slide was last week’s Fed move to change its strategic policy goal, effectively viewing its 2% inflation target as an average over time and allowing it to tolerate periods of above-target inflation.
Of course, the Fed will have its work cut out to get inflation up close to target, never mind back above it. Core inflation was just 1.3% in July and even 10-year inflation assumptions baked into inflation protected Treasuries are still a quarter percentage point below the magic 2%.
All of which means markets assume Fed interest rates will be zero for more than five years at least and it will continue to buy bonds to suppress long-term yields too. U.S. 10-year inflation-adjusted Treasury yields returned to historic lows of -1.1% this week as a result – below euro zone equivalents for the first time in seven years.
For fund managers such as PIMCO, aggressive Fed settings alongside successful action to ease global credit stress during the pandemic both eroded the dollar’s multi-year yield advantage as well as its ‘safety’ bid. More losses beckon, they reckon.
“Any broad-based decline in the dollar is highly likely to lead to appreciation of the euro,” PIMCO strategist Gene Frieda and global portfolio management head Sachin Gupta wrote on Tuesday.
And if the Fed has given itself strategic cover to keep policy rates near zero and Treasury borrowing rates affordable for years to come, then a stark relative inflation picture together with rising euro exchange rate will further nudge the ECB in the same direction.
It may not be ‘currency wars’, but it has similar elements.
Schnabel was keen to avoid easy comparisons, saying: “What is best for the Fed is not necessarily the best for the ECB”.
But as pandemic support sends government debt soaring above 100% of gross domestic product on both sides of the Atlantic this year and next, the last thing they need is embedded price deflation that only lifts the real cost of that debt over time.
Deutsche Bank expects the ECB to use up its entire 1.35 trillion euro pandemic bond buying programme, or PEPP, by the middle of next year and adopt a Fed-like explicit 2% “symmetric” inflation target after its own strategic review in 2021.
And even then, Deutsche doubted it would hit that inflation target over its forecast horizon and expects the ECB will eventually increase its standing asset purchase programme again.
Others go further. Estimating the euro’s trade-weighted exchange rate rise could lop another 0.4-0.5 percentage points off euro zone inflation by the end of 2020, Saxo Bank economist Christopher Dembik said: “We still expect that the PEPP envelope will be increased again by year-end.”
The ECB may well choose to look the other way this month given the huge stimulus it’s already engaged in. But if the euro continues to rise from here, it will be hard to ignore for long.
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