Draghi Disses the Euro

The ECB's acknowledgment that market prices suggest inflation is undershooting its target by half demands more action than policy makers are contemplating. 
Going down?

There are several takeaways from European Central Bank President Mario Draghi's news conference today, none of them heartening to those who fear the euro region is sliding into adeflationary spiral.

Policy makers seems to be in denial that falling prices are a threat; "the current low level of inflation should be followed by a gradual upward movement," Draghi said. Loan demand is picking up just as a new program to funnel cash to banks kicks in -- a triumph of central bank timing, Draghi suggested. And a decline in the euro -- because "the fundamentals for a weaker exchange rate are much better than they were" -- will also help the ECB reach its inflation target, Draghi argued.

QuickTake Deflation

The risk is that those remedies are too little, too late to avert "yield-curve Japanification," as analysts at Royal Bank of Scotland described the collapse in German borrowing costs that has sent 10-year yields to record lows and pushed two-year levels below zero today. This means investors are paying for the privilege of putting their cash in the perceived safety of the German fixed-income market. The following charts illustrate that danger.

Here's what Japanese consumer prices did in the five years after inflation peaked in November 1990, arguably the beginning of the lost decade (or two):


And here are prices in the euro region since October 2011:


Granted, the ECB is much more activist than the Japanese monetary authorities were. Nevertheless, unless Draghi's dictionary has a different definition of "temporary," today's persistently slow inflation should be provoking more concern than it seems to be doing.

The most worrying comments, though, came when Draghi cited where traders and investors are pricing inflation-linked securities, used by pension funds to ensure that future price increases don't erode the value of their income. While acknowledging that the market indicates short-term expectations about inflation rates "have indeed declined," Draghi went on to say that the "universe" of five-year rates is "still anchored at 1 percent," while "medium- to longer-term" securities show inflation expectations of about 2 percent.

That should be a concern. The ECB interprets its price stability mandate at keeping inflation just below 2 percent over the medium term -- not the longer term. I'd suggest that if inflation expectations for the next five years undershoot the ECB's target by half, then that's a problem -- one that demands more action than policy makers are now contemplating.

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