The governors of the European Central Bank are not always the best communicators but this time the message from Frankfurt has come through loud and clear: the ECB is concerned about the continuing low level of European inflation and is prepared to do something about it. Whether it is ready to match words with deeds is another matter.
In his latest press conference, ECB’s president Mario Draghi took the rhetoric up another notch, admitting for the first time that the strengthening of the European currency was a matter of “serious concern” in an environment of low inflation.
He also suggested that ECB governors were not happy with the current low forecasts for inflation and that they would be comfortable taking policy action to confront the problem at the next meeting in June.
Does this mean the ECB is about to launch a UK- or US-style policy of quantitative easing, buying government bonds in a bid to get more cash flowing through the eurozone economy? On balance, we think not, or at least not in the near future.
But it is being given more serious consideration than in the past. Indeed, the governing council has now stated its “unanimous commitment to using unconventional instruments within its mandate to cope effectively with risks of a too prolonged period of low inflation”.
Why the change in tune? The short answer is low inflation and a deeply inconvenient strengthening of the euro. Recent data shows the eurozone economy still improving, but the pace of improvement is still slow. Core and headline inflation are well below target, and there is little inflationary pressure in the economy.
Eventually, the ECB believes the lending figures will start to pick up. But right now it is painfully aware that the momentum in the economy has not been enough to offset the downward pressure on domestic prices from high unemployment and the stronger euro.
The question is whether QE will be the ECB’s first port of call, and whether it would really address the region’s problems.
If QE is going to support credit growth and lending in the weakest parts of the eurozone economy, proponents have suggested the ECB should buy private corporate bonds rather than government debt. This would get around having to buy bonds from all member governments and lessen concerns – in the Bundesbank and elsewhere – about the ECB seeming to finance government deficits.
There are plenty of private corporate bonds the ECB could buy. But spreads in European credit markets have largely been narrowing; almost by definition, the companies that can already access this market are not the ones the ECB would need to help if it were going to make a difference.
That points in the direction of buying asset-backed securities linked to loans to small and medium-sized companies. But this market is tiny in most of the countries that are now in worst shape.
Strong euro is a problem for all
These arguments have tended to silence debates about QE in the past: if it cannot target the problem the ECB needs to fix, why bother doing it all? But the strength of the euro changes the conversation because the stronger currency is a problem for all of the eurozone, not just crisis countries.
And the euro would almost certainly fall – or at least stop rising – if Mr Draghi and his colleagues shocked the world and announced they were going to buy a large amount of government bonds.
We do not think that will happen next month. More modest moves such as a further cut to the main policy rate seem more likely. But ECB officials understand the power of surprise in this environment. They are also painfully aware that their own rhetoric – and the markets’ response to it – may yet force them down the QE path.
If inflation drifts lower again in the next few months, the market will call the ECB’s bluff and it will need to deliver.
Stephanie Flanders is chief market strategist, UK & Europe, at JP Morgan Asset Management