Trouble Brews for ECB as their Inflation Forecasts Could Prove too Optimistic

ECB eurozone inflation

A lack of inflation could reassert pressure on the rallying Euro in coming months, according to new research, which suggests policy-makers at the European Central Bank (ECB) will have to adjust their stance to incorporate the new less inflationary outlook.

The ECB is tasked with ensuring inflation hovers around 2.0% as this is a healthy 'golidlocks' level at which economic growth is not too fast so as to cause financial instability but yet not too slow so as to risk a recession.

The Bank has pumped gargantuan amounts of money into the Eurozone economy in an attempt to stimulate activity and give rise to inflation - a side-effect of the programme is a weaker Euro. 

Currencies tend to weaken when central banks increase stimulus and keep interest rates low whilst they tend to strengthen when they put up rates, as capital seeks out higher returns.

The Euro has gained through 2017 amidst talk that the economy is headed in a direction that will allow the ECB to step back from its money-printing programme at some point in coming months.

However, research suggests that inflation will fall faster than the ECB expects; something that will complicate matters for ECB President Draghi and his team.

“We continue to expect core inflation to undershoot the what is expected in the ECB’s Staff Macroeconomic projections,” says Nick Kounis at ABN AMRO Bank in Amsterdam. “Indeed, we are actually somewhat downgrading our view of core inflation from the already weak profile we had earlier.”

This suggests to Kounis that there is more slack in the labour market, which will keep wage growth depressed for longer.

ABN AMRO expect eurozone core inflation to average 0.9% in 2017 and 1.1% in 2018. This compared to the staff forecasts of 1.1% and 1.4% for those years, respectively.

The unemployment rate is still above estimates of the NAIRU and since 1999 wage inflation has only accelerated once it is comfortably below it.

NAIRU is the Non-Accelerating Inflation Rate of Unemployment and is the level that unemployment must fall below before inflation starts to rise. Simply put, if unemployment can fall further companies can hire without raising wages in an effort to retain and secure new staff.

“Labour market reforms in a number of member states may mean the NAIRU is/will decline compared to current estimates,” says Kounis.

The analyst cites the example of Germany, where despite low unemployment, wage growth remains modest.

What does this mean for ECB policy?

“Normally speaking, one would expect this weak inflation picture to trigger a further ECB QE extension well into 2018. However, we do not expect this. The ECB is running out of room to execute its QE programme given the current rules of the programme. In addition, economic growth is robust,” says Kounis.

So this is a two-edged outcome for the Euro: on the one hand inflation is falling faster than the ECB is expecting and therefore hints at policy staying unchanged which could potentially see some of the currency's gains undone.

On the other, the ECB appears to be running out bonds to buy under its quantitative easing (QE) programme and could therefore have to tighten policy regardless.