Why Europe Needs More ECB Intervention

I noticed something very different at the recent joint International Monetary Fund/World Bank conference held in Washington, D.C. The previous three years had been dominated by discussions of the European crisis, tail risk scenarios and the various potential solutions. But this year, in multiple days filled with more than 60 meetings, only a few focused on Europe. So it seems that not only has Europe turned a corner in terms of economic growth, it’s no longer top of mind for many investors. I agree that the Eurozone’s economy has bottomed. However, with inflation still very low and trending down (also known as disinflation), I believe that unless policymakers proceed carefully, one negative shock still has the potential to derail Eurozone growth, sending it on the path back into recession and potentially even deflation. The European Central Bank (ECB) cut rates on November 7, and because it’s so important for the ECB to show they are willing to proactively reduce deflationary risks, I expect further easing policies in the Eurozone.

  • Eurozone inflation is very low, and trending down.A look at the chart below shows that headline inflation among the 17 EU member states is near the lowest levels since the series began in 1997. The only exception was in 2009, but because this series measures a rate of change, it may be skewed by the fact that food and energy both experienced all-time highs in the economic turmoil in 2008.  Perhaps more troubling, while the numbers are a bit better if you remove the more volatile energy and food prices, those are also trending down.  This may suggest a larger trend.

    Eurozone Headline Inflation Is Falling

    Source: Haver Analytics, as of 9/30/13.

In addition, there is no one source of disinflation; it is broad-based geographically, and at or close to deflationary levels in periphery countries like Greece and Portugal. The following figures from the ECB highlight that headline inflation in many nations has been on a general declining trend since the summer of 2011. 

Disinflation Doesn't Stop at the Border

Source: European Central Bank, data as of 9/30/13.

  • Although a timid recovery is taking place, inflationary pressures are absent in the Eurozone. It is not likely that the expected slow recovery will close the output gap, meaning upward pressure on prices likely will be muted as aggregate demand growth remains tepid. Additionally, a strong currency will effectively import disinflation via cheaper imported goods. As for other sources of inflation, there are no visible supply shocks such as energy, food, or further tax increases that might put upward pressure on prices. In any case, such shocks do not necessarily create sustained inflation but rather have one-off effects. They are also not positive because they reduce real incomes. Additionally, some peripheral countries are implementing structural reforms (such as liberalizing labor and product markets), which typically have disinflationary effects.

Again, I do not believe the Eurozone will enter a period of deflation. However, because of the risk of deflation, the ECB likely will proceed with caution. They surprised markets on November 7 by cutting rates and providing plans for some liquidity measure. This is a good start, but if Japan has taught us anything, it is that once you are in a deflationary zone, it is hard to get out. Therefore, I believe the ECB may need to consider further easing policies that could help provide insurance against deflationary risks and potentially help the fragile recovery. They may also need to be prepared to act quickly with unconventional policies like, dare I say, quantitative easing, in the event that things go awry. Regardless of what path they choose, the message should be that they are willing to be more proactive to reduce deflationary risks. 

Because of all this, I expect further easing policies from the ECB. For investors, this would mean lower interest rates in Europe, especially on the front end of the yield curve (which is generally more sensitive to policy rate changes). Additionally, if policymakers act in good time, we are likely to see a weaker Euro as a result of this disinflationary trend. Therefore, in Oppenheimer International Bond Fund, we have exposure to the front end of curves, as well as a significant underweight in the Euro.

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RP.111113

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