The power of a central bankers’ jawbone is awesome. But there are limits. After a point, words must be backed by actions to have any effect. That point may be approaching in the eurozone.
The story so far: until the summer of 2012, the eurozone seemed to be caught in a death spiral. Confidence in the debt of peripheral countries ebbed, putting pressure on them to leave the euro. That drastic step would have opened for them the option of devaluation, which would make it easier for them to pay their debts.
Then, in the summer of 2012, the new head of the European Central Bank, Mario Draghi, promised to do “whatever it takes” to save the euro. He added portentously: “And believe me, it will be enough.”
The markets believed him. The spread of Italian and Spanish debt yields over German Bund yields is not quite back to pre-crisis levels, but it is close. Conventional wisdom is now that the euro will survive, without even the loss of Greece. And all of this without Mr Draghi ever having to back up his words with action.
The problem now is that the ECB is trying to work the same trick again, this time to avert deflation in the eurozone – described by Christine Lagarde, head of the International Monetary Fund, as the “ogre of deflation”. The trick might not work this time.
A sluggish European economy is a natural consequence of the policies that staved off the debt crisis. The countries whose debt came under threat had to agree to tough austerity programmes that in the short term lead to high unemployment.
The hope is that this pain will eventually lead to a slimmed down economy and resumed growth. The risk is that instead the eurozone slides into a “Japanese scenario”.
Prices fall, thanks to sluggish economic activity. Consumers do not buy now, as goods will be cheaper in future. This lack of consumption slows growth further, and pushes prices down even further.
Inflation in the eurozone has been decreasing for a while, to 0.5 per cent. This is far below the ECB’s 2 per cent target.
Economists expect the eurozone economy to expand, but not fast. The ECB expects 1.2 per cent growth this year, rising to 1.8 per cent in 2016.
The natural response to this would be some form of quantitative easing, known as QE – buying bonds to push down their yields and push up asset prices. The UK and the US have both resorted to this measure.
The ECB, the successor to Germany’s Bundesbank, has a far deeper aversion to inflation than other central banks. But even Bundesbank officials have talked in recent weeks about possible justifications for QE.
But no QE, or indeed any change to monetary policy, was forthcoming at this week’s ECB meeting. Mr Draghi tried to talk down the euro by talking up the possibility of QE – but with no hint that bond purchases were imminent.
In a hypothetical situation of persistent low inflation, the ECB’s board would be “unanimous” in taking “radical” measures. He confirmed that QE had been discussed.
That pushed the euro down but only by about 0.3 per cent in the hours after Mr Draghi spoke. The power of the jawbone is weakening. In any case, Mr Draghi forecast that inflation will move up again, even without QE. Traders must see action as well as words, or they will soon stop listening.
Markets, meanwhile, send contradictory signals. It is hard to make sense of equity valuations unless they assume that Europe will soon receive its own sugar rush of cheap money. European equities are still cheaper than in the US, but then Europe is dominated by companies that tend to trade on lower multiples, such as utilities. Since the “whatever it takes” speech, European stocks have grown faster than those in the US, attracting significant inflows.
Bonds suggest deep concern about deflation. As the chart shows, the yield on German Bunds has not been this far below the yield on equivalent US Treasuries since 2005.
With the Fed removing support for bond prices, while the ECB prepares to support them, a weaker euro against the dollar should result. As the chart shows, this has been the pattern over time, but not now. The euro remains remarkably strong. This is a clear bet by the forex market that the ECB will continue to do nothing.
That creates its own problem. A stronger currency makes exports less competitive, and reduces inflation. Mr Draghi himself estimated that the rise in the euro since its latest low in 2012 has reduced eurozone inflation by about 0.4 percentage points. So if the forex market continues to bet this way, it might force the ECB to act.
The logic points inexorably towards a continent that slowly slides into deflation, with the ECB not resorting to QE until this deflationary pattern is clear – by which time it may be too late.
At present, therefore, buying European equities requires faith that the situation will become so bad as to force the ECB to act. That is a convoluted, and dangerous, rationale.
John Authers
FT
