The ECB cut its main refinancing rate yesterday supposedly in response to weaker-than-expected inflation news. Current inflation trends, however, reflect monetary policy about two years earlier. The ECB pursued a disastrous policy in 2011, raising rates in April and July even though Eurozone real narrow money M1 was contracting. The consequent recession is the main reason for the recent inflation decline.

ECB policy, however, changed dramatically following Mr Draghi’s installation as President in November 2011. Rate cuts and a series of initiatives to relieve pressure on liquidity-short banks and lower funding costs generally resulted in a strong revival in monetary growth in late 2012 and 2013, laying the foundation for the current economic recovery. Monetary trends have faltered recently – see previous post – but remain consistent with economic expansion and do not support deflation worries.

Importantly, recent lower inflation has not been accompanied by a weakening of consumer and business price expectations – in contrast to the inflation drop associated with the 2008-09 “great recession”. The net percentage of consumers expecting prices to rise at a faster pace over the next 12 months is close to its long-term average and has firmed slightly recently – see chart. This firming is consistent with the change from deflationary to reflationary monetary policy that started two years ago.

Yesterday’s cut in the refinancing rate will have little impact on monetary conditions because short-term market rates were below the new level – the introduction of a negative deposit rate would have been much more significant. President Draghi stated that the ECB is not concerned about deflation, consistent with the assessment above. This raises the question of why it chose to act at all. The probable aim was to cool unwelcome euro strength – the trade-weighted exchange rate has risen by nearly 8% over the last 12 months. It would be surprising if such modest action proved effective and the ECB’s efforts may be thwarted by the Federal Reserve, which remains strongly committed to a weak dollar and may reinforce its commitment to its “low for long” interest rate policy over coming months, as well as delaying “tapering”.