ECB would do well to keep rates on hold. For now.
After yesterdays belated market focus on the underlying problems in managing a single strategy for the whole eurozone, it put into sharp focus the policy options facing the ECB. The west has had a ferocious and deadly enemy for the last 40 years, and it was called inflation. All the ammunition and strategy has been directed towards killing this enemy, and the threat has – for the while – gone away. While this battle has been raging however, a new equally deadly foe has arisen; let`s call it deflation.
The problem here is that we had become quite comfortable fighting inflation; we knew the damage the enemy could do, and there were a large range of policy responses that we could resort to. With deflation, it is different. It presents a new threat, but the range of weaponry to deploy against it is much more limited, the mindset needs to be totally changed; and It will not be easy to convince Germany that it must stimulate its economy through an interest rate cut – look to recent comments by Jens Weidmann for confirmation of that.
The debate now starts about when the ECB will cut rates, some now say as early as next week, but when there is limited ammunition, it doesn`t make a lot of sense to use it up straight away. There is a danger that a rate cut now would be seen as a kneejerk reaction to the inflation report, and with rates at these low levels, we are a breath away from `pushing on a piece of string` as far as interest rate stimuli goes. A lower euro will help, but again, that needs to be a lot lower than here, and for a lot longer, to provide the sort of anti deflation push necessary. I think the ECB would do well to hold off from cutting rates, but they will be under a lot of pressure to do so – it would be doubly difficult for them to act if the Euro continues to fall over the next week!
No one is talking about deflation taking hold over the whole of the eurozone at this stage – and it will probably never happen in that way, but my point is that Europe has been geared up to fight inflation, now having to focus on the threat of deflation will require a change in thinking that will really not be easy. Other options such as QE may lay ahead, but I think the ECB should take their time over implementing policies that go against the mind-set of the last 40 years – and more.
After yesterdays belated market focus on the underlying problems in managing a single strategy for the whole eurozone, it put into sharp focus the policy options facing the ECB. The west has had a ferocious and deadly enemy for the last 40 years, and it was called inflation. All the ammunition and strategy has been directed towards killing this enemy, and the threat has – for the while – gone away. While this battle has been raging however, a new equally deadly foe has arisen; let`s call it deflation.
The problem here is that we had become quite comfortable fighting inflation; we knew the damage the enemy could do, and there were a large range of policy responses that we could resort to. With deflation, it is different. It presents a new threat, but the range of weaponry to deploy against it is much more limited, the mindset needs to be totally changed; and It will not be easy to convince Germany that it must stimulate its economy through an interest rate cut – look to recent comments by Jens Weidmann for confirmation of that.
The debate now starts about when the ECB will cut rates, some now say as early as next week, but when there is limited ammunition, it doesn`t make a lot of sense to use it up straight away. There is a danger that a rate cut now would be seen as a kneejerk reaction to the inflation report, and with rates at these low levels, we are a breath away from `pushing on a piece of string` as far as interest rate stimuli goes. A lower euro will help, but again, that needs to be a lot lower than here, and for a lot longer, to provide the sort of anti deflation push necessary. I think the ECB would do well to hold off from cutting rates, but they will be under a lot of pressure to do so – it would be doubly difficult for them to act if the Euro continues to fall over the next week!
No one is talking about deflation taking hold over the whole of the eurozone at this stage – and it will probably never happen in that way, but my point is that Europe has been geared up to fight inflation, now having to focus on the threat of deflation will require a change in thinking that will really not be easy. Other options such as QE may lay ahead, but I think the ECB should take their time over implementing policies that go against the mind-set of the last 40 years – and more.