Since the European Central Bank’s decision to begin outright debt purchases, President Jean-Claude Trichet has argued repeatedly that the central bank isn’t engaging in the kind of quantitative easing that the Bank of England and the Federal Reserve have engaged in during the past 18 months.
He’s right, it’s not.
However, what the ECB is doing is potentially far more worrying.
The ECB is now purchasing the government debt of sovereigns whose solvency is in question: neither the Bank of England nor the Federal Reserve did that.
Let me highlight two specific concerns about what the ECB is doing.
First, a lack of clarity: about decision-making processes across monetary and fiscal policymakers; about how the objectives of the bond purchase program are being defined; and about the prospective scale of the program.
Secondly, a division between ECB members at the outset. The controversy around the ECB’s decision can be seen from the unhappiness of some of the governing council members.
According to the German weekly magazine “Der Spiegel,” Bundesbank President Axel Weber, ECB chief economist Jürgen Stark and the Dutch Central Bank President Nout Wellink were all opposed to the decision.
If this is true, it is hard to overstate its importance.
And besides all that, let’s talk for a moment about inflation expectations in the euro zone.
Necessary economic adjustment is likely to put downward pressure on inflation in peripherals.
We can expect Greek, Spanish, Portuguese and Irish inflation at below euro zone average levels in the next few years.
In the high-debt economies, which have enjoyed strong domestic demand in recent years, the adjustment process may in fact well be disinflationary.
The necessary private and public sector deleveraging is likely to weigh on domestic demand and with a significant share of domestic debt held by non-residents, current account adjustment not only becomes desirable (to rebalance the sources of growth away from weak domestic demand), but also necessary (to finance transfers to foreign debt holders).
Boosting competitiveness would be of great help and given that the external value of the euro is determined by aggregate euro area trends, this will absolutely need to be accompanied by real exchange rate depreciation in peripherals, for example, lower wage-price inflation than elsewhere.
But then, what does this mean for the full aggregate euro area inflation?
Ireland, Portugal, Greece and Spain together account for only 20 percent of the euro area Harmonized Index of Consumer Prices (HICP). Weak demand there may weigh on aggregate euro area inflation.
However, ECB policy rates are set with respect to average demand and supply in the euro area, and weak demand in peripherals may probably be offset by stronger economic activity elsewhere that counts for 80 percent of the total euro zone, while hikes in indirect taxes will support near-term inflation even in the weak economies.
Inflation in Germany, for example, could turn out somewhat higher than on average in the past, which will not be welcomed by the Germans.
Moreover, now the focus on sovereign debt is likely to have added to downward pressures on the euro, which will facilitate the adjustment in peripherals and support growth in externally oriented economies like Germany, the Netherlands, etc.
More importantly, investors should not overlook the fact that the inflation effects (proven) of changes in the exchange rate are significant; for example, a 10 percent depreciation in the effective exchange rate of the euro could push up inflation by as much as 0.7 percent over one year and 1.4 percent over two years.
On a trade weighted basis, the euro is now down close to 6.5 percent since early April and 10 percent since the start of 2010.
Finally, if global growth recovers, as is generally expected, this year and further pressure on commodity prices could remain in place, non-core inflation would support inflation trends, even in domestically weaker economies like Greece, etc.
Altogether, recent developments and the weakening euro have changed expectations for overall euro zone inflation to higher, not lower.
No doubt, this could complicate substantially the EU-IMF bailout operation.
Yes, overall euro zone inflation could become the “joker” in the EU-IMF bailout undertaking.
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