At its 3 September press conference, the European Central Bank (ECB) revised down its economic growth and inflation forecasts as expected, reflecting weaker growth in emerging markets and lower oil prices since its June 2015 forecasts.
The downward revision from 1.5% to 1.1% for the 2016 eurozone inflation projection was substantial. Even assuming inflation turns out to be 1.1% in 2016 (PIMCO forecasts 0.9%), achieving the 1.7% inflation that the ECB projects for 2017 still poses a challenge. Reflecting that challenge, ECB President Mario Draghi noted in his press conference that there are “downside risks to the September staff inflation projections.”
His statement was significant in that it signals the ECB Governing Council has limited confidence in reaching its inflation objective over the next two years, the policy-relevant time horizon. While the ECB’s quantitative easing (QE) program was open-ended from the start, downside risks to the 2017 inflation forecast (see table below) raise the likelihood that the ECB increases the quantity of bonds it purchases each month from €60 billion or continues QE beyond September 2016.
PIMCO believes eurozone core inflation will not rise much further from the current 1% in coming years, reflecting ongoing slack in the economy. Overall unemployment in the eurozone is still 10.9%, and labor market deregulation in countries like Spain and Italy, whose unemployment rates are higher than the eurozone average, will make wages, and thus consumer prices, more sensitive to unemployment.
Investors may note that the increase in the ECB’s issue limit of bonds bought under QE to 33% is marginally positive for short to medium maturity securities, which are the core-country national central banks’ preferred habitat, as well as for European agency bonds. At the margin, this change will reinforce a steep yield curve between bonds of medium and longer maturity and support agency bonds.
And, as with the ECB’s piecemeal path to QE, the debate at future Governing Council meetings will likely be what else can it do? Inevitably, there will be a discussion in some parts of the Governing Council, probably led by the Bundesbank, about whether QE can generate desired inflation outcomes at all. The Bundesbank may get some support from an unexpected corner: “[I]t is difficult at this point to achieve the 2% target in a stable manner through monetary policy alone, unless structural changes that would increase the underlying trend in inflation make further progress.” Sounds like the eurozone, doesn’t it?
Actually, that was Bank of Japan board member Takahide Kiuchi commenting on Japan.