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A Big Week for the Eurozone Deflation Story

25/02/2014 10:32 GMT | Updated 26/04/2014 10:59 BST

Friday 28th will bring what is currently the most important economic release of the month for the Eurozone - the advance estimate for February CPI. Whilst the Fed and the Bank of England flirt with forward guidance and fall in and out of love with the headline unemployment rate as their critical indicator, the ECB has a one-dimensional mandate, i.e. to maintain price stability, defined as inflation at, or just under 2%, over the medium term. The consensus expectation for the CPI estimate is 0.7%, and any number below this will reignite calls for further ECB easing, but the question is which specific piece of armoury might they choose to use - if any?

For the last few months there has been a growing fear that government budget austerity, public and private deleveraging, and the need to restore the peripheral countries' competitiveness, whilst all palpably necessary, are driving the Eurozone inexorably into deflation - that pernicious state of generalized expectation for lower prices in the future, from which, once it is entrenched, it is arguably harder to escape than from rampant inflation. Japan's recent history is the standard exemplar of this. The danger is made even more imminent by the Euro's persistent FX strength.

At previous ECB news conferences Draghi has spoken of two potential catalysts for further ECB action: (a) an "unwarranted tightening of the short-term money markets"; and (b) a "worsening of our medium-term outlook for inflation", so the ECB staff's prognosis for inflation in 2016 will be key - the Governing Council will have these at their disposal for the first time and if they show a medium term uptick at least, towards 2%, then the ECB will probably try and 'see-thru' the current dip, conversely any suggestion in the forecasts that inflation will stay dangerously low will spur the ECB into action.

If the Council is moved to act, then, in order of increasing contention, (but not necessarily efficacy), it can choose to a) cut rates, b) launch another LTRO, c) stop sterilisation of the liquidity injected by the Securities Market Program, (SMP), of sovereign bond purchases from banks, d) purchase private assets, i.e. loans, from banks, perhaps also promoting the securitised market in same by creating CLO's, or e) indulge in pure unadulterated QE.

The problem is that right now I feel there is strong political pressure on the ECB to refrain from 'scaring the horses', in any way, certainly not by embarking on the sort unconventional easing, e.g. QE, that is really now required. All is calm, with even the advent of yet another Italian Prime Minister causing hardly a ripple on the surface of the Eurozone millpond. We are enjoying an uneasy and probably unstable equilibrium, with rich northern Eurozone voters reluctantly convinced of the need for the actions taken thus far, and the periphery reconciled to grinding austerity and appalling unemployment. This pressure has only increased following what many people mistakenly saw as the non-decision by the German Constitutional Court on OMT. In fact, although in the short term they relied upon only a warning shot, and referred the matter to the ECJ, ultimately the Court will have to rule after the ECJ issues its own verdict, and imagine how inflamed the Court, and indeed German public opinion would be if the ECB had in the interim gone even further than OMT, and started full-blown QE, a la the Fed, the BOE and the BOJ?!

The other problem is that all the measures, (apart from perhaps QE), suffer from practical defects of one form or another. Negative Deposit rates may have unintended deleterious consequences for money markets, e.g. to pay for the cost of negative rates on ECB deposits, German banks, say, may just raise loan rates to existing borrowers, rather than extend new loans to the periphery, as everyone would hope. Negative rates also may just cause strong banks to repay LTRO liquidity more quickly, thus tightening money market rates, and a new LTRO may have disappointing uptake in this new era of calm-possibly all the moreso if banks feared that ECB deposits would soon cost them money. Finally, when it comes to purchasing loans from banks, question marks remain over the practical size of any program and this tactic would imply the controversial acquisition of credit risk by the ECB - which would be much easier after the completion of its Asset Quality Review later this year.

I think all-in-all this means that 'unconventional conventional' easing, i.e. a cut in the Main Refinance rate to 15bp, and in the Deposit Rate to -10bp, say, is the most likely choice, but perhaps somewhat confusingly, the Bundesbank has made it clear that it does seem ready to contemplate a halt in SMP sterilisation, (you may think that's because they realise that for technical reasons this won't make much difference in the fight against deflation), so maybe this should be joint favourite.

However, given the political pressure to keep the peace, although it's a very close call, I feel the ECB may hold off completely for another month or two, perhaps behind the smokescreen of marginally improved economic indicators. By that time they may hope that US economic strength and rising US rate expectations may at least have caused the Euro to move lower against the USD.

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