The ECB must launch full-scale QE, say its supporters, because the recent oil price fall will push the economy into “deflation”, defined as a year-on-year fall in headline consumer prices. When this happens, consumers and businesses will stop spending, believing that they will be able to buy more cheaply in the future. Current economic weakness will then turn into a slump.
Hang on a minute. If the decline in the headline CPI is due to oil, why should this affect spending on other goods and services, whose prices are still rising, albeit weakly? Isn’t the opposite impact more likely, i.e. consumers will use the cash released from lower energy bills to spend more on other items before they become more expensive?
Eurozone “core” CPI inflation – excluding energy, food, alcohol and tobacco – is moving sideways not falling: November’s 0.7% was unchanged from December 2013.
You’re forgetting about expectations, retort the QE enthusiasts. The headline CPI fall may be solely due to oil but it will mislead stupid consumers into believing that all prices are about to decline.
What’s the evidence for this unlikely hypothesis? The QE enthusiasts point to falling medium-term inflation expectations priced into bond markets. These “expectations”, however, are partly determined by investors positioning for QE and knowing that market prices will influence the ECB’s behaviour. The circularity makes your head spin.
The classical definition of deflation is a contraction of money and credit that leads to falling prices. Eurozone broad money M3 and narrow money M1 are nowhere near contraction, growing by 2.5% and 6.2% respectively in the 12 months to October.
ECB President Draghi may well push through sovereign QE against German-led opposition in early 2015 but such action is not needed to head off deflation. The effects on the economy and core inflation would probably be miniscule, as in Japan. (President Draghi’s claim that QE was successful in the US and UK is not supported by previous analysis here suggesting little impact on monetary growth.)
The QE debate is obscuring a material improvement in Eurozone economic prospects signalled by monetary trends and leading indicators – see previous post. This improvement is much more important for investors than the QE decision. Stronger-than-expected German manufacturing orders released today are consistent with a developing positive scenario: orders rose by 2.5% in October to their highest since 2011 barring July’s holiday-distorted strength, suggesting that production also increased in the month – see chart.