Mario Draghi can study an array of data this week to help him track his latest policy metric: economic slack.
Inflation figures today showed prices rising at the slowest pace in more than four years. Unemployment tomorrow should also help illustrate the spare capacity left in the euro area by its debt crisis and double-dip recession. As the European Central Bank president meets policy makers to set interest rates on April 3, manufacturing and services surveys might hint at how fast the so-called output gap is closing.
Draghi mentioned slack for the first time after the last meeting to reassure investors that borrowing costs will stay low even as the economy revives, adopting a guidance tool employed by Bank of England Governor Mark Carney only three weeks previously. Unlike indicators such as the jobless rate, which the BOE previously cited as a key threshold, spare capacity is vague enough to give officials plenty of leeway in deciding when to exit ultra-loose monetary policy.
“It’s essentially a way for them to convey to market participants and the public that they don’t intend to tighten policy until the recovery has really got under way,” said Hetal Mehta, a London-based economist at Legal & General Investment Management, which oversees 450 billion pounds ($749 billion). “Slack is very difficult to measure, there’s no agreed way of pinning it down. But we can expect them to keep talking about it.”
The overnight cost of borrowing for banks in euros has been creeping upward as the economy improves. The Eonia rate was at 0.195 percent on March 28, compared with as low as 0.07 percent in November after the ECB last cut official rates.
Inflation in the 18-nation euro area slowed to 0.5 percent this month, according to an initial estimate by the European Union’s statistics office in Luxembourg. The median estimate of economists in a Bloomberg survey was 0.6 percent.
While the figure is distorted by the timing of the Easter holiday, it’s still the slowest pace since November 2009, signaling that companies are struggling to raise prices amid feeble demand. The ECB aims to return inflation to just under 2 percent.
Weak inflation “may put pressure on the ECB to act,” Richard Barwell, senior European economist at Royal Bank of Scotland Group Plc in London, said before the release. “The output-gap reference gives a clear signal that if they don’t do any more, they won’t be tightening any time soon.”
By the time Draghi meets policy makers to decide on rates, he’ll also have jobless figures to help show the state of the euro-area economy. Unemployment probably held at 12 percent in February, highlighting that a near-record share of the labor force is still unable to find work.
The Governing Council will keep the benchmark interest rate at a record low of 0.25 percent, according to 54 of the 57 economists in a Bloomberg News survey. Credit Agricole SA and Danske Bank A/S predict a cut to 0.15 percent, and Goldman Sachs Group Inc. sees a reduction to 0.1 percent.
The ECB also has other tools it could employ to stimulate the economy. Governing Council member Jens Weidmann last week told Market News International that quantitative easing is theoretically possible, as long as it doesn’t infringe the ban on monetary financing of governments. He also said on March 29 in Berlin that officials should only react to “second-round effects” of slowing inflation, which aren’t evident currently.
“The drop in inflation poses a serious downside risk to the ECB’s forecasted inflation trajectory,” said Christian Schulz, senior economist at Berenberg Bank in London. Even so, “the strengthening recovery will lead to gradually falling unemployment and thus falling slack in the economy, which should ease disinflationary pressures,” he said.
Draghi’s comment on the “high degree of unutilized capacity” at his March 6 press conference was reiterated within days by Executive Board members Vitor Constancio, Sabine Lautenschlaeger and Peter Praet.
The gap is “hard to measure, but according to any measure you want to take, it is fairly wide and is estimated, at the present juncture, to be closing itself very slowly,” Draghi said. Interest rates will stay at the present level or lower “even though we will be seeing improvements in the economy precisely because of the existing slack,” he said.
Draghi’s comments echo those by the BOE’s Carney, who said on Feb. 12 that officials at the London-based central bank will keep rates low until there is less slack in the U.K. economy. Policy makers revised their guidance after unemployment fell faster than expected toward a 7 percent trigger for considering a rate increase.
The bank’s Monetary Policy Committee “is for the first time today providing guidance that it is seeking to absorb all the spare capacity in the economy over the next two to three years,” Carney said. The outcome of the next policy decision will be announced on April 10.
Other data this week should signal that the output gaps in both economies are narrowing, when purchasing managers indexes are released by Markit Economics Ltd. Manufacturing and services activity in the euro area expanded at close to the fastest pace in three years in March, according to flash estimates last week.
Even so, the variety of calculations for slack mean it’s hard to judge just when policy makers will reach their goals.
While the ECB hasn’t released its own calculation of spare capacity, there are multiple other estimates for investors to choose from. The International Monetary Fund predicts that euro-area gross domestic product will remain below potential for a sixth year in 2014, at 2.5 percent of potential GDP, and the shortfall will gradually narrow to 0.4 percent in 2018. The European Commission sees the gap at 2.4 percent this year, shrinking to 1.3 percent in 2015.
For the U.K., the IMF forecasts that the output gap will shrink to 1 percent in 2018 from 2.4 percent this year. Britain’s Office for Budget Responsibility said this month that “activity in the economy was 1.7 percent below its sustainable potential level at the end of 2013” and predicted the gap will close by mid-2018.
The BOE estimates that there’s around 1 percent to 1.5 percent of GDP’s worth of spare capacity in the economy. That figure has already been contested by its own officials, with Martin Weale arguing it may be narrower and Carney and David Miles suggesting it may be wider.
The vagaries surrounding the exact size of the output gap play into the hands of policy makers who wish to communicate how they’ll react to economic and market developments without pledging a link to a narrower indicator. Constancio said in Washington on March 22 that while thresholds “would not be useful” for the ECB, officials have to explain forward guidance better.
“Any reaction function contains some element of what slack is doing,” said Nick Kounis, head of macro research at ABN Amro Bank NV in Amsterdam. “What’s revolutionary is the mention of it. In the past, they shied away from being too specific. They’re more confident with the idea now.”