Article / 08 August 2017 at 10:31 GMT

Mario Draghi’s impossible task — #SaxoStrats

Head of Macro Analysis / Saxo Bank
  • Euro area growing less dependent on QE
  • Inflation still evading central bank boosting efforts
  • Structural and demographic changes complicate ECB mandate

By Christopher Dembik

Almost five years ago to the day, European Central Bank president Mario Draghi announced quantitative easing at Jackson Hole, Wyoming, and became in the space of a few months investors’ favorite central banker. He is coming back for the 2017 edition of the Federal Reserve's conference, but this time the result should be quite different since he should seize the opportunity to indicate a change in stimulus settings to come in the autumn.

The bright side

As a matter of fact, the euro area is becoming less reliant on QE. The ECB’s five-year track record is quite impressive.

Economic growth has significantly increased in recent years. The carry-over growth for 2017 is at 1.7% (GDP growth at 0.5% in the first quarter and at 0.6% in the second quarter). Based on the Eurozone manufacturing PMI, GDP could grow by 2-2.2% this year.

Speculation on sovereign bonds has been halted. The Italy-Germany 10-year bond spread is now at only 1.59% versus 4.50% five years ago. In his 2012 speech at Jackson Hole, Draghi justified the launch of QE by higher sovereign premia. "To the extent that the size of these sovereign premia hampers the functioning of the monetary policy transmission, they come within our mandate," he said.

QE implies a currency devaluation effect, which has temporarily increased southern Europe’s price competitiveness. It is estimated that EURUSD’s optimal exchange rate for Spain is about 1.18 and that the optimum falls to around 1.10 for Greece.

Headline unemployment has fallen from its peak of more than 12% four years ago, but the level of slack, which affects around 18% of the euro area extended labor force according to the ECB Economic Bulletin (Issue 3 / 2017), remains a concern.

The ECB’s other expansionary monetary policy measures, such as the targeted longer-term refinancing operations  (TLTROs), continue to support the economic recovery. The last Bank Lending Survey of July 2017 said that "an increased share of banks also reported an easing impact on credit standard" from TLTROs.  

Measure                                                       August 7, 2012             August 7, 2017*
German 10-year bond yield                                              1.47%                               0.48%
Italian 10-year bond yield                                                  5.94%                               2.05%
Euro area CPI                                                                     2.6%                                1.3%
Euro area core CPI                                                            1.5%                                 1.1%
Germany breakeven 5-year                                               1.15%                              1.02%
Euro area unemployment                                                  11.5%                                9.1%

Sources: Macrobond, Saxo Bank Research & Strategy
*Last data available.

However, a quick look at the table above shows that the job is not yet done in terms of inflation. The euro area CPI remains sluggish. Only four countries whose GDP is equal to 4% in the EU (Lithuania, Estonia, Latvia, Austria) have inflation around the ECB's target of  "close to but below 2%". In addition, the euro area core CPI is clearly lagging behind.

The dark side

To understand inflation dynamics, one should recall the three main drivers of cyclical inflation: labour markets (unemployment, productivity, and income), shocks (oil, currency) and money, and expectations (central bank policy, behaviour).

In general, most central banks, including the ECB, refer to CPI to determine the inflation target. However, due to lag in monetary policy, alternative inflation measures may be applied to capture relevant headline inflation shocks linked to commodity prices or exchange-rate fluctuations. One of the approaches to calculating such a price indicator is the concept of domestically generated inflation (DGI). A simple model, such as below, can be composed of the costs least sensitive to external shocks: service prices, GDP deflator and wage growth (which is a key domestic determinant of inflation in neo-Keynesian models).

DGI euro area
We can draw at least two main conclusions from this model applied to the euro area. The first is that it confirms that inflation has been largely pushed up by external factors, especially oil prices, and that labour market trends are still subdued. The Phillips curve is not so curvy anymore; it is getting flat, which means that low unemployment is not stoking wages and inflation. 

Phillips curve for euro area
The second conclusion is that, based on DGI weakening and the appreciation of the euro (ECB’s June staff projections were at 1.09 for EURUSD), it is highly probable that the ECB will be constrained to revise its inflation forecasts downwards for the coming years and keep monetary policy loose much longer than expected by the governing council.

The underlying forces keeping inflation low are complex. As the economist Scott Summers likes to say "monetary policy works with long and variable lags". No one is able to predict whether or when the massive monetary creation that has taken place after the global financial crisis will lead to much higher inflation or even, as some economists fear, hyperinflation.

I can only agree with such humility. We don’t know everything. Nonetheless, I have a feeling that "lowflation" is primarily a structural phenomenon that is here to stay. It is linked to technological deflation (1) and ageing population (2).

(1) For the first time ever, a top ECB official, Yves Mersch, has acknowledged that technological progress is impacting monetary policy: "Changes in the overall rate of technological progress affect the interest rates central banks set. As such, policymakers need to adjust policy settings to adapt to changes in the real economy" (Conference in Kuala Lumpur, on July 24, 2017). More and more evidence shows that global labour abundance and technological progress, such as robotisation, which will destroy jobs at least in the short term, are fueling deflationary growth and preventing widespread wage increases that could spur CPI.

(2) Ageing is also crucial to explain structural lowflation. In most developed countries, the largest population cohort is associated with  baby boomers (net savers) while the cohorts behind are relatively smaller than in the past (predominantly net borrowers). The consequence is that there are fewer opportunities for savers to deploy their abundant savings. The borrowers hold the cards in today’s lending market. So the cost of capital can only remain low to encourage more borrowing.


  • In an open economy, central banks are not all-powerful and struggle to  influence inflation dynamics directly and durably, which will probably lead to a change in their mandate. 

  • The ECB will have to keep its monetary policy loose much longer than expected, maybe for a decade, due to structural changes at work. Investors will certainly not welcome a tapering of QE, which is inevitable because of technical constraints (bond scarcity) and political considerations (pleasing the Germans). But they should keep in mind that the central bank policy rate will remain extraordinary low for a very prolonged period of time, providing low cost of capital to the market. 

  • A long period of low inflation opens the door to new monetary policy instruments, such as a Taylor-type rule, including demographics, so the natural rate would move with growth in the working age population and it would certainly confirm the need for low interest rates, or new innovative measures, like "quantitative easing for the people" or QEFP (also known as "helicopter money"), but the impact on inflation and growth is yet to be determined. 

— Edited by John Acher

Christopher Dembik is head of macro analysis at Saxo Bank
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