More Posts
Looking for more information on fixed income trends and market opportunities?
The ECB’s Narrowing Window to Tackle Chronically Low Euro Area Inflation
- By Katharine Neiss, PhD, Chief European Economist, Global Macroeconomic Research
- October 23, 2020
The European Central Bank’s supercharged policy coupled with the euro area’s unprecedented fiscal expansion has provided the region with measurable support through the Covid pandemic. Some recent volatility in euro area inflation has prompted speculation about how these policy responses may affect the outlook for inflation. However, when looking through the volatility, the longer-term downward trajectory of inflation remains intact, giving the ECB a narrowing window to build consensus and head off the concerning trend before it becomes even more entrenched.
Measuring inflation involves capturing the general movement in prices, which is a difficult exercise under normal conditions. Yet, attempting to ascertain price movements during a pandemic-induced lockdown can become little more than a guessing game. While the euro area experienced some volatility in inflation over the summer, there are several other short-term, virus-related factors currently affecting inflation readings.
A portion of the recent volatility reflects measurement issues related to the pandemic, including delays in typical summer sales patterns and the simple unavailability of many prices, requiring them to be imputed as part of the inflation data. The pandemic-amplified measurement issues likely say more about shifts in relative prices rather than a general increase in prices.
Furthermore, there are other short-term factors that have recently weighed on inflation, including temporary cuts in value-added taxes by several countries as they looked to stimulate demand, and lower energy prices. Finally, as a large and open economic region, the recent appreciation in the euro amidst reduced fragmentation concerns is expected to continue feeding through to headline inflation with a dampening effect in the coming months (Figure 1).
Figure 1: Recent Strength in the Euro Has Dampened Inflation Pressure in the Short Term
When looking through these near-term factors, the inflation concern is not to the upside as some may fear. Rather it is the relatively quick reversion to the existing pattern of weak underlying inflation, which continues a worrying trend that predates the pandemic (Figure 2). Indeed, euro area headline inflation has averaged 1.3% over the last decade, well below the ECB’s stated inflation target of below, but close to, 2%. More recently, core inflation reached an all-time low of 0.2% in September.
Figure 2: Euro Area HICP—A Decade of a Downward Trajectory (year-over-year % change)
A number of secular factors explain this trend decline, such as demographics, technology and globalisation (click here for additional research on global inflation). The current crisis has added a further dimension to the downward trajectory in the form of significant spare capacity that has opened across Europe as demand fell markedly in early 2020.
The Policy Response
Clearly the ECB’s monetary policy response to the coronavirus crisis has been exceptionally supportive. But as recently as late 2019, Governing Council members were divided on the need for additional monetary easing against a backdrop of declining inflation. Quantitative easing looked to have run beyond its political limits and policymakers were either unable, or unwilling, to do more in order to achieve their target. Even then, there was the risk of a downside de-anchoring of inflation. With the ECB’s latest staff projections continuing to point to below target inflation, that risk is still very much alive.
At a Crossroads
The ECB’s ongoing, but delayed, monetary policy framework review—which is set to be a more comprehensive assessment than the Federal Reserve’s recently revised framework—signals a crossroads for the central bank as it provides policymakers with a fresh opportunity to demonstrate its commitment to achieving their price stability mandate. Some members of the Council have been voicing their relatively dovish views. Villeroy de Galhou, Governor of the Bank of France, noted that “we may be prepared to accept inflation above 2% for a period of time without mechanically tightening our monetary stance.”1 Hernandez de Cos, Governor of the Bank of Spain, highlighted that “the degree of tolerance of above inflation deviations is the same as for below-target deviations.”2
A consensus therefore appears to be emerging in favour of the adoption of a symmetric 2% target with an emphasis on policy flexibility in relation to that target and more prominence placed on the ECB’s “second tier” mandate of supporting the general economic policies of the Union, including balanced growth, full employment, and even addressing climate change. The review is not due to conclude until mid-2021, and in the interim, significant challenges around consensus building, particularly with more hawkish members of the Governing Council, need to be overcome.
Whatever the conclusion, the words of ECB policymakers will need to be backed by policy action. Other central banks that have fallen into the disinflationary trap would likely counsel swift action. The ECB faces a narrowing window to act decisively and arrest the decade-long trend of sliding inflation across the euro area before it becomes further entrenched.
This material reflects the views of the authors as of October 23, 2020 and is provided for informational or educational purposes only. Source(s) of data (unless otherwise noted): PGIM Fixed Income.
1SUERF Online Conference, October 14, 2020.
2“The Role of the European Central Bank’s Monetary Policy in the COVID-19 Crisis,” Deusto Business Alumni Meeting, October 1, 2020.
Katharine Neiss, PhD
Katharine Neiss, PhD, is a Principal and Chief European Economist for PGIM Fixed Income, based in London. Ms. Neiss covers the macro-economic outlook in the UK and euro area, including Bank of England and ECB policy. Prior to joining the Firm in 2020, Ms. Neiss was Head of the International Surveillance Division at the Bank of England, responsible for briefing policymakers on the global macro-economic and financial stability outlook. Previous roles at the Bank of England include Head of the Policy, Strategy and Implementation Division, covering regulation of major UK banks, and senior manager roles in the Structural Economic Analysis Divisions, covering the UK economy. Ms. Neiss has published several articles in peer reviewed academic journals on topics ranging from real interest rates as a monetary policy tool and the impact of the global financial crisis on supply. She received a BA Honours in Economics from Queen’s University and holds a Masters and PhD in Economics from the University of British Columbia.
PGIM Fixed Income operates primarily through PGIM, Inc., a registered investment adviser under the U.S. Investment Advisers Act of 1940, as amended, and a Prudential Financial, Inc. (“PFI”) company. Registration as a registered investment adviser does not imply a certain level or skill or training. PGIM Fixed Income is headquartered in Newark, New Jersey and also includes the following businesses globally: (i) the public fixed income unit within PGIM Limited, located in London; (ii) PGIM Netherlands B.V. located in Amsterdam; (iii) PGIM Japan Co., Ltd. (“PGIM Japan”), located in Tokyo; (iv) the public fixed income unit within PGIM (Hong Kong) Ltd. located in Hong Kong; and (v) the public fixed income unit within PGIM (Singapore) Pte. Ltd., located in Singapore (“PGIM Singapore”). PFI of the United States is not affiliated in any manner with Prudential plc, incorporated in the United Kingdom or with Prudential Assurance Company, a subsidiary of M&G plc, incorporated in the United Kingdom. Prudential, PGIM, their respective logos, and the Rock symbol are service marks of PFI and its related entities, registered in many jurisdictions worldwide.
These materials are for informational or educational purposes only. The information is not intended as investment advice and is not a recommendation about managing or investing assets. In providing these materials, PGIM is not acting as your fiduciary. These materials represent the views, opinions and recommendations of the author(s) regarding the economic conditions, asset classes, securities, issuers or financial instruments referenced herein. Distribution of this information to any person other than the person to whom it was originally delivered and to such person’s advisers is unauthorized, and any reproduction of these materials, in whole or in part, or the divulgence of any of the contents hereof, without prior consent of PGIM Fixed Income is prohibited. Certain information contained herein has been obtained from sources that PGIM Fixed Income believes to be reliable as of the date presented; however, PGIM Fixed Income cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. PGIM Fixed Income has no obligation to update any or all of such information; nor do we make any express or implied warranties or representations as to the completeness or accuracy or accept responsibility for errors. All investments involve risk, including the possible loss of capital. These materials are not intended as an offer or solicitation with respect to the purchase or sale of any security or other financial instrument or an y investment management services and should not be used as the basis for any investment decision. No risk management technique can guarantee the mitigation or elimination of risk in any market environment. Past performance is not a guarantee or a reliable indicator of future results and an investment could lose value. No liability whatsoever is accepted for any loss (whether direct, indirect, or consequential) that may arise from any use of the information contained in or derived from this report. PGIM Fixed Income and its affiliates may make investment decisions that are inconsistent with the recommendations or views expressed herein, including for proprietary accounts of PGIM Fixed Income or its affiliates.
The opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients or prospects. No determination has been made regarding the suitability of any securities, financial instruments or strategies for particular clients or prospects. For any securities or financial instruments mentioned herein, the recipient(s) of this report must make its own independent decisions.
Conflicts of Interest: PGIM Fixed Income and its affiliates may have investment advisory or other business relationships with the issuers of securities referenced herein. PGIM Fixed Income and its affiliates, officers, directors and employees may from time to time have long or short positions in and buy or sell securities or financial instruments referenced herein. PGIM Fixed Income and its affiliates may develop and publish research that is independent of, and different than, the recommendations contained herein. PGIM Fixed Income’s personnel other than the author(s), such as sales, marketing and trading personnel, may provide oral or written market commentary or ideas to PGIM Fixed Income’s clients or prospects or proprietary investment ideas that differ from the views expressed herein. Additional information regarding actual and potential conflicts of interest is available in Part 2A of PGIM Fixed Income’s Form ADV.
In the United Kingdom, information is issued by PGIM Limited with registered office: Grand Buildings, 1-3 Strand, Trafalgar Square, London, WC2N 5HR. PGIM Limited is authorised and regulated by the Financial Conduct Authority (“FCA”) of the United Kingdom (Firm Reference Number 193418). In the European Economic Area (“EEA”), information is issued by PGIM Netherlands B.V., an entity authorised by the Autoriteit Financiële Markten (“AFM”) in the Netherlands and operating on the basis of a European passport. In certain EEA countries, information is, where permitted, presented by PGIM Limited in reliance of provisions, exemptions or licenses available to PGIM Limited under temporary permission arrangements following the exit of the United Kingdom from the European Union. These materials are issued by PGIM Limited and/or PGIM Netherlands B.V. to persons who are professional clients as defined under the rules of the FCA and/or to persons who are professional clients as defined in the relevant local implementation of Directive 2014/65/EU (MiFID II). In certain countries in Asia-Pacific, information is presented by PGIM (Singapore) Pte. Ltd., a Singapore investment manager registered with and licensed by the Monetary Authority of Singapore. In Japan, information is presented by PGIM Japan Co. Ltd., registered investment adviser with the Japanese Financial Services Agency. In South Korea, information is presented by PGIM, Inc., which is licensed to provide discretionary investment management services directly to South Korean investors. In Hong Kong, information is provided by PGIM (Hong Kong) Limited, a regulated entity with the Securities & Futures Commission in Hong Kong to professional investors as defined in Section 1 of Part 1 of Schedule 1 (paragraph (a) to (i) of the Securities and Futures Ordinance (Cap.571). In Australia, this information is presented by PGIM (Australia) Pty Ltd (“PGIM Australia”) for the general information of its “wholesale” customers (as defined in the Corporations Act 2001). PGIM Australia is a representative of PGIM Limited, which is exempt from the requirement to hold an Australian Financial Services License under the Australian Corporations Act 2001 in respect of financial services. PGIM Limited is exempt by virtue of its regulation by the FCA (Reg: 193418) under the laws of the United Kingdom and the application of ASIC Class Order 03/1099. The laws of the United Kingdom differ from Australian laws. In South Africa, PGIM, Inc. is an authorised financial services provider – FSP number 49012. In Canada, pursuant to the international adviser registration exemption in National Instrument 31-103, PGIM, Inc. is informing you of that: (1) PGIM, Inc. is not registered in Canada and is advising you in reliance upon an exemption from the adviser registration requirement under National Instrument 31-103; (2) PGIM, Inc.’s jurisdiction of residence is New Jersey, U.S.A.; (3) there may be difficulty enforcing legal rights against PGIM, Inc. because it is resident outside of Canada and all or substantially all of its assets may be situated outside of Canada; and (4) the name and address of the agent for service of process of PGIM, Inc. in the applicable Provinces of Canada are as follows: in Québec: Borden Ladner Gervais LLP, 1000 de La Gauchetière Street West, Suite 900 Montréal, QC H3B 5H4; in British Columbia: Borden Ladner Gervais LLP, 1200 Waterfront Centre, 200 Burrard Street, Vancouver, BC V7X 1T2; in Ontario: Borden Ladner Gervais LLP, 22 Adelaide Street West, Suite 3400, Toronto, ON M5H 4E3; in Nova Scotia: Cox & Palmer, Q.C., 1100 Purdy’s Wharf Tower One, 1959 Upper Water Street, P.O. Box 2380 – Stn Central RPO, Halifax, NS B3J 3E5; in Alberta: Borden Ladner Gervais LLP, 530 Third Avenue S.W., Calgary, AB T2P R3.
© 2021 PFI and its related entities.
