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Losing anchor

22 August 2014 By Swaha Pattanaik

The case of the euro zone’s vanishing inflation rate has so far stumped European Central Bank President Mario Draghi. Quite rightly, investors’ faith in his ability to do anything about the problem is also evaporating.

The clearest sign is a sharp decline in the ECB’s preferred barometer of market inflation expectations, which tracks how investors see inflation behaving over a five-year period beginning five years from now. At first glance, the measure’s modest drop – from 2.12 percent at the end of July to this week’s 1.94 percent low – doesn’t seem to reflect scepticism in the ECB’s ability to lift inflation back up to its 2 percent medium-term target. But things aren’t that simple.

Immune to the blips and dips of monthly data, the “five year/five-year forward” gauge rarely moves much. Yet it has just suffered its biggest four-week decline since 2012, and is now at its lowest since 2011, according to Credit Agricole. More sensitive indicators of inflation expectations have fallen even lower.

Most of the blame lies with a perfect storm of gloomy economic news. The euro zone inflation rate has fallen to 0.4 percent, its lowest since 2009, partly due to falling fruit and vegetable prices. To make matters worse, a Russian ban on European Union meat, fish, poultry, dairy, fruit and vegetables has fanned concern that a glut of discounted fresh foodstuffs might weigh further on inflation in the short term.

Granted, that would be a temporary phenomenon. But prices won’t rise without a pick-up in economic activity. Gross domestic product in the euro zone remained flat in the second quarter as Germany and Italy contracted while France stagnated. This is even before euro zone exporters feel the impact of regional sanctions against Russia.

The ECB has already taken some steps. Its deposit rate is below zero, and banks will be offered a new round of cheap loans in September. But market prices show investors are concerned that this is too little, too late. Given the economic backdrop, the doubts look justified.


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