Investors show lack of faith in ECB’s inflation credentials
Christine Lagarde has plenty on her plate. As she oversees her first monetary policy decision this week, the new European Central Bank president has vowed to reforge a consensus on the governing council, pressure eurozone governments into spending more, and put the environment at the heart of monetary policymaking.
But one similarly daunting task is central to the ECB’s mandate: convincing investors that the central bank can bring inflation back to its target of below but close to 2 per cent.
Despite rock-bottom interest rates and a renewed programme of asset purchases, inflation expectations in eurozone financial markets are hovering close to all-time lows. Investors are pricing in annual inflation of little more than 1.2 per cent in the second half of the next decade, according to so-called five-year five-year inflation swaps — an indicator of long-term inflation expectations closely watched by the ECB.
Last month, this measure dropped below the core inflation rate — the central bank’s preferred measure of where inflation is today — for the first time, suggesting investors believe that inflation will keep slipping away from the central bank’s target.
Bets on ultra-low inflation stretching far into the future are also visible in bond markets. Vast swaths of eurozone debt, including nearly all of Germany’s, trade at a sub-zero yields. If fund managers believed the ECB would get close to achieving its mandate over the coming three decades, buying German 30-year bonds at a yield of just 0.18 per cent would make little sense.
This lack of faith in the ECB’s ability to fulfil its one and only policy goal is problematic for a central bank that has relied on its ability to convince investors it means business — most notably in Mario Draghi’s crisis era pledge to preserve the euro.
“It can’t be healthy that the market questions the effectiveness of all this easing,” said Richard Barwell, head of macro research at BNP Paribas Asset Management. “It undermines confidence if you are seen to give up. That really matters next time you need to convince people you will do whatever it takes.”
There is little sign that investors expect Ms Lagarde to abandon the stimulus efforts of her predecessor Mr Draghi. One reason bond yields remain so low in the eurozone is investors’ expectation that the €20bn-a-month programme of asset purchases that began in November is set to continue for a long time, and could be scaled up if the economy worsens. Markets are also pricing in further cuts to the ECB’s deposit rate from the current level of minus 0.5 per cent, despite mounting concerns about the unwelcome side effects of negative interest rates.
“We expect Lagarde to explicitly tell the market the ECB can do even more,” said Franck Dixmier, head of fixed income at Allianz Global Investors. “There’s a very clear personal commitment to pursue and endorse what Draghi has done — that’s been evident from day one.”
Mr Dixmier, however, does not expect this extra stimulus to produce the sort of inflation that could upset bond markets. He is also relaxed about the central bank continuing to undershoot its target, as long as low inflation does not slip into outright price declines. “It’s very important to look at what the inflation swap market is telling you — that there’s no deflation priced in,” Mr Dixmier said.
Some observers caution against reading too much into the prices of bonds and inflation swaps when gauging inflation expectations, arguing the ECB’s asset purchases have distorted the signal from these markets.
“It’s unwise for central bankers to ascribe too much information content to market prices that are themselves influenced by the central banks,” said Marie Owens Thomsen, chief economist at Swiss wealth manager Indosuez. “It’s a bit like a dog biting its own tail.”
Instead, the ECB should relax its inflation target to a 1-3 per cent range — copying Sweden’s Riksbank — as part of its upcoming policy review, Ms Owens Thomsen thinks.
“There’s a strange perception that very low inflation is a problem,” she said. “But as long as it’s taking place in an environment of growth, it’s more like economic nirvana.”
Still, allowing low inflation expectations to take root could end up being self-fulfilling — a point made by rating agency Fitch, which recently warned over the potential for “Japanification” of the eurozone.
So far, Ms Lagarde has shown no sign of backing away from the commitment to the current target. Notably, though, she has repeatedly warned governments including Germany’s that they should use their large budget surpluses to stimulate the economy — taken by some as a tacit admission that the ECB is running out of options for further monetary easing.
Some investors see the new ECB boss’s focus on the environment in a similar light. “Perhaps this is why she’s talking about climate change so much,” said one fund manager. “Saving the world probably seems like an easier task than meeting the inflation target.”