An alarming drop in euro zone inflation – to 0.7 percent from 1.1 percent – throws today’s European Central Bank policy meeting into very sharp relief. Not since the central bank cut interest rates in May has it been under such scrutiny.
No policy change is likely, and “sources familiar” are already talking down the threat of deflation. But the central bankers, who are mandated to target inflation at close to 2 percent, will be alarmed at the sight of price pressures evaporating. One need look no further than Japan to see the damage deflation can do, often for many years.
We reported last week that a strengthening euro has also come onto the ECB’s radar, given it could depress both growth and inflation, and that there are three camps – one wanting an interest rate cut (which we know was discussed at the last meeting), another preferring to keep the option open of another long-term liquidity flood for the banking system as was done last year, and a third wanting to do nothing.
The euro has since dropped quite sharply, it should be noted, but unless inflation starts picking up a little, the likelihood of some action before long grows significantly. Our latest poll of 59 economists predicted the ECB would inject more liquidity into the banking system, probably early next year. That was conducted before the last inflation figures came out and the odds on a rate cut to 0.25 percent are now tumbling fast. The December meeting, when the ECB will produce updated growth and inflation forecasts, is a more likely date.
Today, expect Mario Draghi to indulge in some robust verbal intervention – warning that he and his colleagues stand ready to act and still have an arsenal at their fingertips. He has not tended to indulged in the coded wordplay of his predecessor, Jean-Claude Trichet, but watch out for a dusting off of the “strong vigilance” phrase which in years gone by indicated a rate move slightly further down the road (though in Trichet’s days it signalled a rate rise not cut).