By Max McKegg
The Governing Council of the European Central Bank
is serious about sparking life into inflation but won’t change policy until it sees the whites of its eyes. That was the message delivered by President Mario Draghi in his press conference following last week’s policy meeting. He said the ECB intends to have a “sustained presence” in the bond markets indefinitely and “tapering was not discussed”.
Combine the Brent crude and exchange rate alternative paths and you have headline inflation significantly above the ECB target of “below, but close to, 2%”. Photo: iStock
It seems the possibility of the quantitative easing program sparking too much life into inflation, introducing upside risk to their “below, but close to, 2%” target, is so far-fetched as to not warrant consideration. “We seem to be fairly far away from any such high-class problem” said Draghi.
But the ECB staff macroeconomic projections, released after the meeting, paint a different picture, especially in light of market developments subsequent to the projections being finalised on November 17. The baseline inflation forecast is illustrated by the solid blue in the chart below, showing the headline rate rising at 1.3% next year, 1.5% in 2018 and 1.7% in 2019. This path does does not fit the definition of “below, but close to, 2%” according to the Governing Council. Hence the need to try harder.
The shaded area represents a possible margin of error, based on the staff’s forecasting track record. But it also shows what’s likely to happen if an “alternative path” for key variables such as EURUSD
and Brent crude
Source: European Central Bank
Discussing the outlook for inflation, Draghi said “the risk of deflation has largely disappeared” but there are “no signs yet of a convincing upward trend in underlying inflation”. What he didn’t add was that the staff projections show there is a credible scenario where headline inflation (the ECB’s benchmark) will hit 2.5% by 2019, and unless the Governing Council has developed a one-track mind after years of fighting off deflation, exceeding the target should be just as concerning as falling short.
Unlike the Bank of Japan, the US Federal Reserve
and the Bank of England, the ECB has refrained from suggesting it has any tolerance for breaching the inflation target to the upside. Therefore, as monetary policy acts with a long lag, any such possibility should be nipped in the bud well before it becomes a probability. The ECB would need to pull the plug on the QE program abruptly.
Under what scenario would 2.5% inflation loom on the horizon ?
First, we need to look at the main technical assumptions underlying the baseline forecast that inflation will only rise to 1.7%. These are that the price of a barrel of Brent crude will rise to $54.60 by 2019 while EURUSD will hold at around 1.09.
Under a “sensitivity and scenario analysis” where the price of oil rises to $65, the staff model indicates headline inflation would be increasing at a rate of 1.8% in 2018 and 2.00% in 2019. Some of this is “banked” already because since the baseline forecasts were finalised on November 17, oil has had a good rally, as illustrated in the chart below. A continuation up to $65 by 2019 doesn’t look too much of a stretch anymore.
Brent crude (click to enlarge)
If the alternative path for the exchange rate plays out, the inflation rate will get another boost. It assumes EURUSD will decline to 0.95, about 10% below the baseline assumption of 1.09. This isn’t a number plucked out of thin air; rather it’s based on option pricing (for the nerds: “the 25th percentile of the distribution provided by the option-implied risk neutral densities for the EURUSD exchange rate on Nov 17 2016”)
Under this scenario the rate of inflation would rise by an extra 0.4%-0.5% in both 2018 and 2019.
Again, some of this is already banked because EURUSD is down closer to 1.06 as of today. The baseline assumption (1.09) and the alternative path (0.95) are shown in this chart.
EURUSD scenarios (click to enlarge)
Combine the Brent crude and exchange rate alternative paths and you have headline inflation in the euro area at 2.3% in 2018 and 2.5% the year after, in each case significantly above the ECB’s target of “below, but close to, 2%”.
And given the time delays inherent in monetary policy, if this scenario looked like it might occur the bank would need to take pre-emptive action; not just tapering the asset-purchase program but pulling the plug on it altogether – because no one knows what dangers lurk if the inflation genie is let out of the bottle.
Trading Floor is running a series of “Outrageous Prediction for 2017
”. Not only tapering QE in mid-2017, but halting it in its tracks, would certainly be an outrageous prediction, as far as Mario Draghi is concerned. But as the ECB staff projections show, its not all that far-fetched.
– Edited by Susan McDonald
Max McKegg is managing director of Technical Research Limited. If you would like an email notice each time Max posts a trade or article then click here or post your comment below to engage with Saxo Bank's social trading platform.