Draghi’s Deflation Risk Complicates Recovery: Euro Credit

Mario Draghi is facing down a deflation threat with few options left to fight it.

Consumer prices in the euro area are rising at the slowest pace in four years, well below the European Central Bank’s target of just under 2 percent. The ECB president has a choice of cutting rates that are already near zero, injecting liquidity that may not boost prices, or ignoring the ECB’s own definition of price stability, according to banks including JPMorgan Chase & Co. and BNP Paribas SA.

A price slowdown could turn into a negative spiral that derails the recovery in the euro region. While the 17-nation economy exited six quarters of recession in the three months through June, it still has record unemployment and shrinking bank lending.

“The ECB has become unusually tolerant of low inflation, even by its own standards,” said Greg Fuzesi, an economist at JPMorgan in London. “The argument for inaction is becoming more stretched, however. The refinancing rate cut is the simplest option in the near term.”

Euro-area inflation slowed to 0.7 percent in October, the lowest level since November 2009 and the ninth straight month that the rate has been less than the ECB’s ceiling, European Union data showed yesterday. Price gains are sluggish amid a fragile recovery and a strengthening euro that cuts the price of imports.

Rate-Cut Predictions

The euro depreciated 0.7 percent to $1.3493 today, headed for the biggest weekly slide against the dollar since July 2012. German two-year yields dropped to 0.11 percent, the lowest level since July this year. Benchmark 10-year bund yields rose to 1.697 percent after falling to 1.65 percent yesterday, the lowest level since Aug. 8.

The report prompted speculation the ECB will invoke policies from a reduction in its benchmark interest rate, currently at a record low of 0.5 percent, to adding fresh liquidity to the financial system, or broad-based asset purchases similar to those by the U.S. Federal Reserve.

Bank of America Corp., UBS AG and Royal Bank of Scotland Group Plc now forecast a rate cut at this month’s meeting on Nov. 7. BNP Paribas, Societe Generale SA, JPMorgan Chase, ABN Amro Bank NV, Nomura Holdings Inc. and Scotiabank predict a reduction in December, when the central bank will publish new economic projections.

Inflation Undershoots

“Inflation is persistently undershooting the ECB’s definition of price stability, which risks unanchoring inflation expectations on the downside,” said Ken Wattret, chief euro-area economist at BNP Paribas in London. In addition, “the appreciation of the exchange rate is leading to an inappropriate tightening of financial and monetary conditions in the euro area.”

So far, Draghi has held his nerve when it comes to the threat of deflation. Judged by their actions, ECB policy makers are now more sanguine about price gains well below 2 percent than in the past. Even though the central bank forecasts inflation will average 1.3 percent in 2014, it hasn’t signaled that’s low enough for it to cut rates.

Neither has the ECB indicated it’ll act to halt a rising euro. The single currency has appreciated more than 4 percent against its major peers since late March and rose to a two-year high against the dollar last week.

Euro Gains

An appreciation of 10 percent in trade-weighted terms has the same effect as an interest-rate increase of 0.5 percentage point to 1 percentage point, according to calculations by Nordea Markets last month. Erik Nielsen, chief global economist at UniCredit SpA in London, said such a gain would shave off 0.8 percentage point of gross domestic product over two years, with most of the impact in the first 12 months.

The ECB has warded off calls for U.S.-style quantitative easing and opted instead to provide banks with unlimited cash for as long as three years. The euro-area economy relies on bank lending for about 70 percent of credit, making asset purchases a more difficult policy tool to use. Securities account for about 70 percent of financing in the U.S.

Draghi may simply wait for the nascent euro-area recovery to lead to an acceleration in price gains. Business confidence as measured by the European Commission increased for a sixth month in October to the highest level in more than two years, while manufacturing and services output has expanded since July, signaling the recovery in the euro area is gaining strength.

‘Positive Sign’

Low inflation may even help growth, according to Christoph Weil, an analyst at Commerzbank AG in Frankfurt. Periphery nations are cutting labor costs as they strive to reduce a euro-region unemployment rate that stood at 12.2 percent in September.

“The low rate of inflation is a positive sign, as it is largely due to weak price pressure in the crisis countries,” Weil said. “Declining prices in Greece and Spain confirm that companies are using the drop in unit-labor costs to improve their price competitiveness.”

Draghi has sent mixed signals on how to handle consumer prices. In June, when annual gains were averaging 1.6 percent, he said low inflation is not necessarily bad. “With low inflation, you can buy more stuff,” he said. A month later, he reiterated that “price stability goes in both directions,” signaling that undershooting the ECB’s target is just as dangerous as exceeding it.

Northern Resistance

“We expect headline inflation to fall further in the coming months, which would leave the single currency area vulnerable to a deflationary episode in the case of a negative demand shock,” said Nick Kounis, head of macro research at ABN Amro in Amsterdam. “A November move is possible but not probable, given that there is still resistance by officials from some of the northern member states. They and the rest of the council will probably want to wait for the updated inflation projections in December.”

Bundesbank President Jens Weidmann has warned repeatedly that interest rates kept too low for an extended period carry risks that are hard to gauge. Ewald Nowotny, Austria’s representative on the council, said in an interview with Market News International published on Oct. 29 that policy makers are unlikely to cut their benchmark or the deposit rate.

“Draghi has to have a higher tolerance for low inflation,” said Carsten Brzeski, senior economist at ING in Brussels. “He can hardly do anything against it.”

(For more on Europe’s debt crisis, see TOP CRISIS. To receive this column daily, click SALT EUCREDIT.)
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