BoAML | Even with structural reforms, trend GDP growth may not be consistent with comfortable debt sustainability in key peripherals by the time inflation normalizes.
If the euro area does not make progress towards fiscal union in the meantime, the ECB will likely have to remain involved on the bond market.
Accepting inflation overshooting – which we think would be in the Euro area’s interest – is a way to solve the equation.
For this to be politically feasible, there must be enough commitment to reforms and some degree of fiscal responsibility in the periphery, and commitment to the Euro area’s project in core. All this is for later consumption, but the elections in Spain on 26 June, the referendum in Italy in October and finally the general elections in Germany in September 2017 will be key moments on the way.
ECB’s relishing its peace and quiet: time for some long term thinking
The ECB is enjoying its peace and quiet amid “goldilocks” dataflow: core inflation is low enough to justify the magnitude of the March 2016 package (we’re back to where we were in December 2014, when ECB was mulling the first version of QE), while the real economy is strong enough to avoid a discussion on doing more for now. Even the Fed’s communication has been kind to the ECB this week, with the Minutes released earlier this week revealing a more hawkish than expected spirit at the FOMC. At 1.12, the euro currency is not an issue for the ECB. No “unwarranted tightening in monetary conditions” is forcing Frankfurt into an uneasy discussion on further depo cuts, which in our view is the last thing the European banking sector needs to hear at this juncture.
Of course, the ECB must be vigilant and they still have plenty to worry about. The EU referendum in the UK on 23 June is an obvious concern. But at this stage the board’s minds are probably more focused on the “how” – how to implement the corporate bond programme, how to reconcile the ECB’s jobs as bank supervisor and monetary policy-maker – than on the “where next”, at least this is the message we think was intended in the ECB minutes.
Periods of relative calm offer space for some medium term thinking. Our starting point is the juxtaposition this week of the European Commission deciding not to decide on potential breaches of European fiscal rules in Spain and ECB’s Erkki Liikanen statement that inflation overshooting is an “arithmetic” consequence of achieving inflation close but below 2% in the medium after “a long period of stagnating prices”. We think that inflation overshooting is the “natural slope” for the Euro area in the medium term given the incapacity of the central bank to fully extricate itself from public debt sustainability issues by the time inflation gets closer to 2%.
We reiterate that after the summer we expect the ECB will quickly be drawn in a thorny discussion on how to continue QE after March 2017 – which we think will be necessary. We also consider that the continuation of such policy may well exceed the end of our forecasting horizon (December 2017).
*Image: Foter / Abendglanz
