Taper Time!

Inflation in the Eurozone spiked to 1.8% in January, the highest level in almost four years! More importantly, 1.8% is also extremely close to the ECB’s inflation target of ‘below, but close to, 2%.’ Hence, there is no immediate reason for more QE, right?

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Wrong! As Mr. Draghi already told us last December, the ECB will continue buying large quantities of Eurozone bonds. The ECB will be blowing up its balance sheet until at least the end of this year, with the only nuance that from March it will buy ‘just’ EUR 60 billion of bonds per month instead of the current EUR 80 billion. That said, it’s highly unlikely that the ECB will abruptly stop buying bonds from 2018. So, expect more to come.

But is all this additional QE really necessary? I’m inclined to say ‘no.’ One of the most popular arguments to keep going is that the current inflation spike is a temporal one, driven by higher oil prices. No argument there, as the graph below shows. The current rise in inflation coincides with an impressive, year-on-year rise in the price of oil. It’s likely that inflation will fall back a bit if oil prices stay where they are right now. But the opposite must then also be true. In 2016, Eurozone inflation was, again temporally, pulled down by a collapse of oil prices in the year before.

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To circumvent the volatile effects of oil prices (and food prices) central bankers also look at core inflation. But before I turn to this metric, let me emphasize that the ECB, in all its wisdom, chose headline inflation as its only goal. Adding core inflation to substantiate your unconventional monetary policy feels a bit like cheating, but hey…

Currently, Eurozone core inflation lies just below 1%, which is considerably lower than the ECB target. However, core inflation is positive and does not strike me as a level that should cause panic. Core inflation has fallen below 1% before, at the end of the nineties, albeit briefly. But anyone with some knowledge about the effects of financial crises, among them a sustained period of very low or even negative inflation, wouldn’t get all that nervous about the current level of core inflation. Add to this the major bear market in commodity prices, to a large extent caused by Chinese overcapacity, and that 1% actually looks pretty reasonable.

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Inflation expectations are another argument for ongoing QE. When inflation expectations fall too much, people start to anticipate low or even negative inflation for an extended period of time. Sounds fair, inflation expectations are probably a better central bank target than realized (rear-view mirror) inflation numbers anyway. But even inflation expectations have recovered significantly in recent months. Even in the Eurozone. The graph below shows one example of inflation expectations, inflation swaps. This recovery is not just because of rising oil prices, but also because of stronger economic growth, lower unemployment, higher wages, and rising home prices.

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Why then is the ECB going full steam ahead with its QE program? Well, obviously because Mr. Draghi is Italian. Probably not, but Italy certainly has something to do with it. If roughly 20 years of Eurozone has taught us anything, it must be applying a ‘one-size-fits-all’ monetary policy to all member states is a bad idea. As a result, this policy should at least fit the weakest member states. Obviously, Italy matches that description. No growth, almost no inflation, high unemployment and a massive amount of debt. So, the ECB keeps throwing money at it. Better to be safe than sorry, right? But as the charts above show, the necessity for QE is much less evident on an aggregate level. In fact, where ECB bond buying functions as a lifeline for Italy, it’s actually pretty superfluous for Germany. Hence, expect the discussion on ECB tapering to intensify in the coming months.

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