The Eurozone consumer prices dropped 1.4% during the month of January. Deflation was expected and the euro barely reacted to news.
Inflation expectations in the Eurozone dropped to record low levels in February. The 5y5y inflation swap rate tanked to 1.38% this month following a steep slope off the 1.80% level in December 2015. This was just before the ECB disappointed the market by a 10 basis point cut in deposit rate only and a six month expansion in its QE program.
Despite the ultra-expansive monetary policy, the ECB failed to generate inflation in the Eurozone and the future outlook is clearly not bright.
Both internal and external factors prevent Super Mario from reviving consumer appetite to spend and the inflation to pick up toward the 2% target. It is a fact that the 75% drop in oil prices and similar cheapening in commodities interfered with ECB’s plans to generate a surge in consumer goods prices. The slowdown in emerging markets’ demand, led by China, a succession of political events as the Eurozone sovereign debt crisis, Greek tragedy, the migrant crisis and the Brexit risks offers a poor playground to Eurozone policymakers. Latest figures showed that the zone’s power engine, Germany, exported 0.6% less in Q4 and the expectations in February fell below the 100 mark for the first time since October 2014 according to IFO.
Despite the gloomy outlook in the Eurozone and the expansive monetary policy, the euro appreciated. Investors preferred increasing their euro exposure as the global economic risks surged. The euro has found, to its demise that it is now treated as a safe-haven currency with investors. The single currency gained almost 7% against the pound since the beginning of the year and 1.43% against the US dollar despite the 25 basis point hike in Federal funds rate in December 2015.
Fed tightening expectations have faded. Many expected an additional 1% rise through 2016, now the consensus appears to have pared back to a ‘one-and-done’ scenario, all things being equal.
The market prices in a tiny 8% probability for a March rise from the Fed. The EURUSD is holding its break above the 1.10 mark although there is little doubt that Super Mario is certainly attempting to plot something creative in Frankfurt.
Unfortunately, the ECB may be running out of resources in terms of capacity to surprise. The ECB can certainly ease more, but could it ease to an extent to satisfy the market?
While actual prices remains subdued, the lofty inflation target has in some respects lost its meaning. Higher inflation comes as a result of economic recovery and growth and is therefore pointed as a monetary policy goal. On the flipside, higher inflation weighs on households’ purchasing power and should not be seen as an energy boost for a developed economy where the major part of the population is unwilling or unable to spend owing to limited disposable income and already high indebtedness. It is clear that the monetary easing failed to generate sustainable and good results in terms of real economy. The ultra-expansive monetary policies have, in contrary, widened the gap between the financing channel and the real economy. Real projects are incapable of finding the healthy financing to materialise. The basic concept of risk-to-return is broken.
Fed’s Lacker summarized the facts in one phrase: ‘successive rounds of QE have had little or no tangible effect on economy.’
Draghi has a point. Monetary policy is only a small piece of the puzzle. Unless we see major restructuring, reforms and fiscal stimulus amongst all Eurozone states in concert with the low interest environment, it will fail to have the desired effect.