Europe's Rate Cut Will Work, but Only if the Market Believes

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Inflation is a touchy issue in Europe. After years of fearing high inflation, Europeans now face the opposite problem: very low, even negative, inflation. In an attempt to remedy that, European Central Bank President Mario Draghi surprised markets by cutting interest rates and announcing plans to buy asset-backed securities, a step toward a European version of quantitative easing (QE).

It’s not certain whether QE will get inflation closer to the ECB’s 2 percent target. If it does, it won’t be because Draghi is pumping more euros into the economy; it will be because investors are persuaded that higher inflation is credible and under his control. It’s part mind game, part bluff, and the markets, so far, seem optimistic that it will work. The figure below is the five-year break-even inflation rate (the difference between nominal and real bonds) for the euro zone. The break-even is an indication of what markets expect inflation to be over the next five years.

After trending downward for months, inflation expectations registered a 15-basis-point increase after Draghi’s announcement. Even though overall expectations are low, the uptick is a positive sign. Expectations determine wage contracts, investment decisions, and asset prices, which is part of what makes inflation a self-fulfilling prophecy.

Whether markets are persuaded—and if so, how long they’ll stay that way—remains to be seen. Similar measures failed to spark inflation in Japan in 2001: Despite having increased the monetary base by 60 percent, Japan experienced years of deflation. QE in the U.S. has had mixed results. Early rounds of buying mortgage backed assets had a positive effect on the economy; later rounds barely registered. The euro zone still faces structural impediments to growth, which may mean that Draghi lacks the tools to get to a 2 percent inflation rate. For now, he’s doing all he can to persuade markets otherwise.

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