The ECB is once again confronted by a problem: Inflation and in particular inflationary expectations are falling in the Eurozone. For example, the flash estimate for German inflation in the month of March amounted to 1.5% (Y/Y), which was below our forecasts. Inflationary expectations for the EMU have truly plunged recently, and currently lie at around 1.3%, or the same as the nadir of 2016, when the ECB ramped up its QE programme to EUR 80 bn per month. The core rate of inflation, which excludes the components of energy and food, has been oscillating between 1% and 1.2% for years. In other words, the prolonged upturn phase has not been reflected in inflationary developments.
The reaction function of the ECB is essentially rooted in changes in inflationary and growth expectations. Accordingly, the ECB should actually be cutting interest rates now in order to ward off the threat of deflation before it becomes a reality. But with interest rates stuck at zero and a negative deposit rate, this is obviously a very difficult thing to do. The ECB’s first response was therefore to remove from the market any expectations of a possible interest rate rise later in the year. As a result, Bund yields are now negative up to maturities of ten years.
If inflation were to stabilize at current levels, interest rates would then remain at their current levels for a relatively long period of time. But in the event of further declines and the spectre of deflation raising its ugly head, the ECB would – based on its modus operandi to date – be forced to act and come up with new instruments. The drawback of such an approach, however, is that the side-effects of these measures will become increasingly problematic. So it would be better for the ECB to not respond at all initially. It may also be the case that inflation will not react – or will barely react – to weaker growth on this occasion, just as strong growth has also failed to spark a rise in inflation in recent years.
And in the medium term, the ECB and all other central banks should be analysing whether inflation is still suitable as a key control parameter of monetary policy. The current structural changes in economies are clearly leading to a significant weakening of existing transmission channels between growth and inflation. However, an efficient central banking system is absolutely essential for a financial system with lasting stability. This issue therefore needs to be discussed soon, before an excessively low global interest rate environment triggers a global crisis.