World Economy

Eurozone Inflation to Undershoot ECB Target

Having kick-started growth and averted the threat of deflation, policymakers will have to debate whether to conclude bond buys in after September
Currency market volatility remains high on the agenda.Currency market volatility remains high on the agenda.

Eurozone inflation may need more time to rise than anticipated as spare capacity is taking longer to exhaust but the European Central Bank should not accept price growth below its target, Belgian policymaker Jan Smets said.

With inflation pressures muted, the ECB has not even started a discussion about revising its monetary policy framework or even its so-called forward guidance, as the current setup serves the currency bloc well, Smets told Reuters in an interview.

In a nod to years of rapid growth, the ECB dropped a longstanding pledge last week to increase bond buying if needed, a small step on the road in ending a €2.55 trillion ($3.14 trillion) stimulus scheme.

But inflation is proving to be notoriously difficult to boost and will likely undershoot the ECB’s target of almost 2% for years to come so policymakers gave few if any hints that they are willing to end bond buys this year as markets now expect.

“It will take somewhat more time to get to the objective than we thought earlier,” Smets said. “The level of potential output may have become higher due to structural reforms and... slack may be bigger.”

“It may take more than we thought and inflation pressures could take more time to build,” Smets added. “(But) it is absolutely crucial that we meet our price stability objective and not accept a level below that; the objective is what it is and we are not there yet.”

Investors are now looking for clues about the ECB’s next move in dismantling stimulus and the cautious comments from Smets suggest the bank could continue moving only by increments.

Measuring growth capacity and slack in a large and heterogeneous currency bloc is notoriously difficult but with growth consistently surprising on the upside and inflation on the downside, current estimates may be off, Smets argued.

FX Focus

Smets added that even if currency market volatility did not feature as prominently in ECB President Mario Draghi’s news conference last week, the issue remains high on the agenda.

“We absolutely continue to look at the exchange rate and it would be wrong to assume that we pay less attention than a few weeks ago,” Smets said.

“We expect exchange rate movements to correspond to fundamentals,” he said, referring to the euro’s rise in recent months, influenced in part by US policymakers stated desire for a weaker dollar.

Having kick started growth and averted the threat of deflation, policymakers will have to debate whether conclude bond buys in after September but Smets said this discussion has not yet started.

Even a debate about revising the bank’s forward guidance, flagged in earlier meetings, has not yet started as debate this month focused of removing the pledge to raise bond buys, if necessary, the ECB’s so-called easing bias.

Italy Storing Up Trouble

The next Italian government could derail the Franco-German talks on eurozone reform. It was revealed this week that eight small northern European countries, led by the Netherlands, are opposing reforms because their governments reject the idea of fiscal transfers.

Italy, too, has reasons to resist them, albeit different ones. The reforms would strengthen the role of the European Stability Mechanism, the €500 billion bailout fund created in 2012 at the height of the crisis in the eurozone.

But as a quid-pro-quo, Germany and others insist on semi-automatic debt restructuring. No Italian government could sign up to this. There is now a clear risk that the reform package proposed by Emmanuel Macron, the French president, might fail or, at best, turn out to be rather modest. It used to be that Franco-German agreement was both necessary and sufficient for any EU reforms to get through. That is no longer the case.

Another risk is an Italian fiscal overshoot. This is a very probable scenario, no matter whether Di Maio becomes prime minister, or the job goes to Matteo Salvini, the leader of the anti-immigrant and anti-euro League. The two parties were the big winners in the election.

The fiscal overshoot could fuel debate about a parallel currency as a soft alternative to a euro exit. There is a lot of excitement among some Italian economists about “fiscal money”, as it is also known. The idea is to use the tricks of modern finance to create something that performs functions resembling those of money, but that remains outside the control of the central bank.

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