The latest inflation data in the eurozone will not be greeted with joy in Frankfurt, as the annual core eurozone inflation number dropped to 0.2%. This is the lowest level ever recorded for the core eurozone price index and far below the implicit target of the ECB of “below but close to 2%” in the medium term. Considering the rising number of coronavirus infections in Europe and the renewed lockdowns, it is not likely that we will see a quick rebound of eurozone inflation numbers in the coming months.
Before we look at the implications for future ECB policies, let’s see how we got into this mess in the first place. At the start of the euro in January 1999, we had just witnessed the great interest rate convergence, as central banks in southern Europe reduced their interest rates to align with the German Bundesbank. The Italian Central Bank cut its official rate with no less than 6% in three years before the ECB took over. The Spanish Central Bank cut even more, from an official rate close to 10% in 1996. We saw a similar convergence of inflation rates in this period, with inflation rates in the periphery dropping close to 2% and German inflation nearing 1%. The Bundesbank handed over the monetary keys to the ECB with reasonable confidence that the eurozone would continue the German policy of a strong currency and an emphasis on keeping inflationary pressures under control.
The honeymoon was cut short
In the first few years of the euro, all seemed to go according to plan: once inflation moved above 2% throughout the eurozone, the ECB hiked rates to slow down the economy and inflation dropped below 2% again. Looking back, this was the honeymoon period for the eurozone as inflation remained stable around target and we still saw decent economic convergence between the member states. But in 2003, the ECB was forced to cut rates as German growth remained stubbornly low, also causing it to breach the Maastricht deficit ceiling of 3% for several years. While the German economy could certainly use a bit of monetary support, historically low interest rates created a credit and housing bubble in periphery countries. Inflation and growth numbers started to diverge across the eurozone, while the ECB stuck to its stimulative measures.
Once the ECB started to hike interest rates in 2006, periphery economies were overleveraged and overheating and were hurt significantly in the financial crisis. Core inflation fell below 1% during the crisis but managed to rise again above 1.5% as the economy rebounded. Some analysts pointed to the prolonged period of inflation not meeting the target, but the ECB board was happy to hike rates, as suggested by its hawkish economist Jurgen Stark. The subsequent sovereign crisis was the first real test of the euro as a single currency area and caused a massive exodus out of ‘anything periphery’ by Northern European investors. Periphery countries went through a prolonged period of financial deleveraging, while their governments were forced to cut budget deficits in the middle of this crisis via harsh austerity programs.
The analysis and medicine prescribed by Brussels and Berlin was that these countries lacked competitiveness and should cut wages and government spending to converge to the German model of export-based growth. Even though it is understandable that German (and Dutch) politicians were demanding change after bailing out Greece and other periphery countries, in my view these plans also resulted in steadily declining eurozone inflation rates. While German industry flourished with a combination of high productivity growth and low wage growth, other countries had to depend mostly on cutting wages and spending to improve competitiveness. Of course other factors certainly contributed to the steady decline of inflation rates, like the downward pressure on prices due to globalization and the ageing European societies, but these probably did less damage compared to the excessively tight fiscal policies.
From balanced budgets to fiscal expansion
Under the creative leadership of Mario Draghi, the ECB did everything in its power to push inflation towards its target. After cutting the official rate to zero, the ECB started to buy sovereign and other bonds in considerable quantities. But none of these measures managed to lift core inflation, which remained stuck at around 1%. All it would take was another economic crisis to push this number to zero, as we have found out this year with the coronavirus outbreak. The economic crisis and resulting drop in demand has pushed prices of many goods and services lower and we can assume that this will continue for a prolonged period. Pricing power for the European service industry will remain subdued, especially in the travel sector. The ECB responded quickly and forcefully to the crisis, but there is simply not a lot it can do to support demand and prices for services. Cutting rates further will result in more pain for its banking system, which is already suffering from margin pressures. Expanding its balance sheet will probably only result in tighter spreads on periphery bonds and potentially lift equity prices.
I am a lot more positive on the fiscal measures taken by the eurozone countries. Germany has clearly changed its view on government deficits, with a pledge to continue its prolific spending. The EU agreement to set up the European Recovery Fund to lift future economic growth also shows that the focus on balanced government budgets has been replaced with plans for significant fiscal stimulus in the coming years. True to its nature, the EU is still discussing the final terms, but eventually it will get to an agreement signed by all member states.
Christine Lagarde will have some difficult ECB board meetings ahead and will be also be grilled by the financial press on her plans to get inflation back on track. Another complicating factor is the appreciation of the euro in the last few months, gaining more than 5% on a trade-weighted basis. With the recent Fed announcement that it will keep rates around zero for the next couple of years and the Bank of England getting closer to cutting rates below zero, we might see a further appreciation. The ECB does not have a lot of options left in its monetary toolbox and it will have to depend on more fiscal action to see any further economic recovery and at some point a rebound of inflation. It is likely that the ECB will announce a sustained period of stable official rates, in line with the pledge of the Fed. It will also continue to support fiscal expansion with further increases in its purchase programs. This rocky road will take several years before we can tell whether the considerable eurozone fiscal expansion will be sufficient to get inflation anywhere near the ECB’s target.
Author: Hendrik Tuch, Head of Fixed Income at Aegon Asset Management. To find out more contact your financial adviser.
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