ECB Drops Anchor as Deflation Looms
European Central Bank President Mario Draghi has disappointed investors and economists by failing to detail the size of the expansion he's seeking in the central bank's balance sheet. This much is clear from today's investment bank research reports. Parsing Draghi's comments from yesterday, as his favorite inflation measure fell to a record today, raises the chilling prospect thatit may already be too late to avert deflation in the euro region -- and that he knows it.
For the first time, Draghi has abandoned the incantation he's used for months against the perceived evils of falling prices: "Inflation expectations for the euro area over the medium to long term continue to be firmly anchored." That's how he put it in his opening remarks at the August monetary policy press conference, and then followed it up, at the question-and-answer session, with, "Long-term expectations remain anchored at 2 percent."
Last month, the phrase was absent from his speech, but surfaced in the Q&A, albeit with a caveat: "The inflation expectations we've seen, they are still anchored. But we've seen the risks, the downside risks increasing." Yesterday, in addition to dropping the mantra from his speech, Draghi also demurred when he was directly asked if he thought inflationary expectations were anchored:
Well, first of all, the inflation expectations -- first of all, we don't use -- let me get this clear, because there has been a certain amount of misunderstanding in the last few weeks -- we don't use one single measure of inflation expectations. We use a broad range of indicators. And our inflation expectations measures have gone down especially on the short horizons and are now around 8 points below 2 percent on the five-year on five-year, and so we look at that with -- definitely with great attention. I would say that the measures we've taken have been determined exactly because our medium-term outlook on inflation expectation has worsened and we see that the risks have increased.
Lena Komileva, the chief economist at G Plus Economics in London, a research company, interpreted the absence as a sign the ECB is aware that the euro region risks what she calls "Japanification." Annual inflation was just 0.3 percent last month; it hasn't touched 2 percent since January 2013.
That drift is reflected in the derivatives market, where inflation swaps -- used by pension funds and other large investors to guard against higher prices eroding the value of their future cash flows -- are flashing danger. Here's a chart showing Draghi's preferred gauge of inflation expectations, using the five-year rate on inflation swaps in five years' time, collapsing to a record today:
Draghi's comment yesterday that "the governing council is unanimous in its commitment to using other non-conventional measures" suggests he's confident he can persuade his reluctant central banking peers, notably the Bundesbank, to accede to full quantitative easing if the economic backdrop doesn't improve. His other words, though, suggest that whatever the ECB comes up with next will be too little, too late.
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