The European Central Bank unexpectedly cut interest rates at its November policy meeting. It took down the main refi rate by 25 basis points to a new low of 0.25%, while leaving the deposit rate unchanged at 0.00%. The ECB's decision caught the majority of financial market participants off-guard. Most had correctly anticipated that the greater-than-expected decline in eurozone inflation—from 1.1% in September to 0.7% in October—would set the basis for further monetary easing. However, most had priced in December as the month for the move, coinciding with the publication of the ECB's new round of macroeconomic forecasts, as the likely delivery date. Forward guidance may have become de rigueur for the purposes of monetary policy formulation worldwide, but the ECB clearly likes to reserve the right to surprise.
Irrespective of timing, the rate cut has been broadly interpreted by financial markets and media as a sign of the ECB's concern about the possibility of a Japan-like deflationary spiral developing in the eurozone. However, the ECB disagrees with that interpretation. While acknowledging that inflation is likely to remain fairly low for a protracted period, outright deflation is only seen as a tail risk.
Signs of rapidly decelerating price pressures have been evident in the eurozone periphery for a while. Annual inflation rates in countries like Spain and Greece stood in negative terrain in October, and at or near zero in Portugal and Ireland. A fair part of this decline can be accounted for by last year’s administrative price hikes falling out of calculations and the drop in import prices—mostly energy—courtesy of a strong (probably too strong) euro. However, there is no negating that depressed domestic demand in these economies must also be playing a part in pushing consumer prices down.
One of the problems for the ECB is that well over a decade after the introduction of the single currency, financial markets continue to struggle with the notion that the bank does not speak for individual countries but for the eurozone as a whole. It may well be the case that some of these eurozone peripheral economies may go through something of a temporary deflationary phase. However, for the ECB this is but part of the natural rebalancing of cost-competitiveness between the periphery and the core in a situation where politically-led currency devaluation is no longer an option for national governments. In other words, this was always part of the script.
The problem is that in order to fully adhere to the script, the core economies should be adequately compensating via higher inflation to keep the eurozone inflation in sync with the ECB's price stability target of close to 2.0%. And this is not the case—or to be precise, it is not enough the case right now. Indeed, inflation rates in countries such as Germany and the Netherlands are also trending down. Here also, the effects of administrative prices falling out of calculations—in the case of the Netherlands, for example—and the strong euro are clearly playing a part. Others like to point the finger at Germany's unwillingness to stimulate its own domestic demand. Irrespective, the end result is a threat to the ECB's legally bound mandate to achieving price stability in the eurozone as a whole. This the ECB cannot put up with. Hence the rate cut and the uncompromising pro-easing forward guidance.
With Frankfurt speaking loud and clear, all eyes are now on Berlin, where Chancellor Angela Merkel is deep in negotiations for the formation of her second grand coalition. Critics of Germany's obsession with current account surpluses would probably draw some comfort from the fact that the government emerging from these coalition talks would probably have more of a domestic demand bias. Minimum-wage legislation seems high on the cards, as does a stronger focus on public investment in domestic infrastructure. If so, the chances of domestic prices pressures creeping up in Germany—within measure, of course—would increase going forward.
