Although the Eurozone recovery remains on track, slowing inflation and euro appreciation is putting pressure on the ECB to loosen monetary policy further this week. However, ING Investment Management does not expect a rate cut (yet). Also the euro does not seem to be much overvalued. Meanwhile, markets are again more driven by liquidity.
The output gap in the Eurozone has steadily widened since 2008 which implies consistent downward pressure on domestically generated inflation. As the graph shows, inflation in the euro region is on a clear downward trend since the end of 2011.
Developments of EUR/USD and inflation since 2007
Pressure on ECB to loosen policy further
The slowing inflation highlights how sluggish the region’s recovery is. In October, inflation fell from 1.1% in September to a lower than expected 0.7%, the lowest rate since late 2009. Core inflation (ex food and energy) also fell and is now just 0.8%.
The ongoing decline in inflation, combined with the rise in the euro, is therefore set to increase the pressure on the ECB to loosen monetary policy further. The possibility of a further cut in the policy rate, or new liquidity measures in the form of an LTRO (long-term refinancing operation), is however not a forgone conclusion as the central bank’s governing council seems to be quite deeply divided. Slowing inflation and the appreciation of the euro are arguments in favour of a rate cut, while the improvement - while still fragile - in the real economy and the expectation that inflation will pick up next year (the ECB’s inflation forecast for 2014 is 1.3%) are the main reasons cited by those favouring no change in policy.
Despite the pressure to loosen policy further, the central bank may yet wait until its December meeting when the new quarterly ECB staff macroeconomic projections will provide more insight. This week President Draghi might state that the risks to inflation have shifted to the downside and that an interest rate cut is a possibility, in a bid to - at least temporarily - halt the euro’s rise and keep interest rate expectations low.
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