Negative inflation hits Eurozone, ECB to print and distribute one trillion euro earlier than expected

The new ECB premises in Frankfurt am Main, Germany (the tower on the right). (ECB Audiovisual Services 28/11/2014).

The new ECB premises in Frankfurt am Main, Germany (the tower on the right, in the forefront). (ECB Audiovisual Services 28/11/2014).

This week more indications emerged pointing to the possibility that the European Central Bank is to announce a government bond purchases programme sooner than expected. Negative inflation of -0.2% (deflation) in Eurozone during December (announced yesterday by Eurostat), brings this prospect much nearer. The latest information related to the government bond purchases by the ECB was given by Mario Draghi in an interview with the German business newspaper Handelsblatt published on 2 January.

On that occasion Draghi said “The purchase of government bonds is one of the tools in our toolbox, which we can use to fulfil our mandate…We are making technical preparations to alter the size, pace and composition of our measures in early 2015, should it become necessary to further address risks of a too prolonged period of low inflation. The Governing Council agrees unanimously on that”. This clearly means that the ECB is technically ready to launch such a project whenever its Governing Council decides so.

The Germany opposition

Of course Germany objects to a programme of mass purchases of government bonds. More so if it includes debt paper issued by all member states including the crisis hit countries Greece, Cyprus, Spain and Portugal. Berlin insists that if the ECB buys sovereign debt, it will help the big spenders of the South to relax their efforts to reduce deficits. However, most members of ECB’s Governing Council seem to support Draghi’s argument, that the central bank is obliged by its mandate to buy government debt now, along the lines of its prime duty to maintain price stability.

The President of the central bank insists that “The risks of not fulfilling our mandate of price stability are in any case higher than they were six months ago”. This brings us to the latest developments, indicating that such action is closer than expected. Most important of them are the fall of the euro/dollar parity below the 1.20 benchmark and the sudden fall of the December inflation rate in Germany to 0.1% from 0.5% in November, while Eurozone inflation turned negative in December with -0.2%. Let’s take one thing at a time.

Things change fast

One of the main factors which influence the euro/dollar parity, probably the most important one, is the monetary policy applied by the American central bank, the Fed, in relation to EC’s strategy. Towards the end of December, the Fed governor Janet Yellen had deferred the decision to start charging an interest rate on the refinancing of banks, currently at zero percent, for the middle of 2015. This announcement should have eased the strength of the dollar vis-à-vis the euro. Economic logic says that the more accommodative the quantitative easing is for the banks the more money spins around, and consequently the less its value compared with the other major currencies. This was not the case for the euro/dollar parity in the first week of the year.

Instead of that the dollar further strengthened in relation to the euro from 1.21 $ / € on 30 December, it fell to below 1.19 yesterday. A logical explanation is that the money markets (who know everything!) expect more euros to be printed and circulated sooner than expected. That’s why they devalued the euro a bit more. Everybody knew that the ECB is preparing to extend its monetary easing policy measures, to include government bond purchases. It seems that now money markets estimate that this prospect is coming closer.

The ECB is ready

As Draghi has stated, the Governing Council has unanimously asked the relevant committees of the central bank to prepare the technicalities and the conditions for this operation, including purchases of Greek state debt. To be reminded that the ECB has already started buying covered bonds and Asset Backed Securities. In order to finance all those monetary operations, the Council has also unanimously agreed to increase ECB’s balance sheet by one trillion euro, from €2 to €3tn. Understandably, most of it will be used to buy Eurozone government bonds. The closer this prospect comes, the lower the euro/dollar parity will fall.

The next important indicator that this operation is to be realised earlier than thought is a new fall of inflation. According to Eurostat, inflation was negative (deflation) in four EU countries in November, Spain, Poland, Greece and Bulgaria and pegged between zero and 0.1% in seven more member states. During that month, inflation in Germany was 0.5%, not an alarming figure.

Shivers from negative inflation

However, last Monday, the German Federal Statistics Office announced that, in accordance with the common EU statistical standards, inflation in this country fell sharply in December to a mere 0.1%, while according to Eurostat’s flash estimate which was released yesterday, overall inflation in Eurozone was negative during the same month at -0.2%. Both those developments are quite alarming and must have shaken some people in Berlin, like Wolfgang Schäuble, the Federal minister of Finance, and Jens Weidmann, the Governor of the German Central Bank the Bundesbank.

Both of them are low inflation lovers, but measurements below zero obviously become a problem even for them, because the next thing may be an ugly deflation of some percentage units as in Greece. If the reader cannot understand why close to zero or negative inflation is such a problem, it suffices to mention that this triggers a vicious cycle of price and wages decreases, which may end up in a full economic crash of the 1929 kind.

Draghi is right

For the Germans, negative inflation presents one more problem. It solidifies Draghi’s position for more quantitative easing in the Eurozone. Undoubtedly then, the purchase of government bonds is nearer that most of us thought. After all, this is not the first time the ECB buys government bonds. It did so in 2010 and 2011 to save the German and the French banks from the burden of Italian, Spanish, Greek, Irish and Portuguese government bonds. But at the time Berlin and Paris didn’t raise the question if this was within the mandate of ECB. Oh no! The German banks had to be saved at any price.

Turn and twist it as they may in Berlin, the truth remains that the ECB has to help the real economy by printing and distributing one more trillion. There will be a collateral damage though; the major banks will be the first to profit, much more that the unemployed youths of Europe.

 

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  1. Be at liberty to put up someplace, I couldn’t work out the right way to add them right right here.

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