ECB playing with fire as deflation draws closer.

http://www.telegraph.co.uk/finance/financialcrisis/10743334/Immobile-ECB-playing-with-fire-as-deflation-draws-closer.html

A warning sign next to the new headquarters of the ECB. Mario Draghi admitted that the ECB was caught off-guard by the sudden dip in inflation last month
Ambrose Evans-Pritchard By Ambrose Evans-Pritchard8:12PM BST 03 Apr 2014 Comments95 Comments
The European Central Bank has finally opened the door to quantitative easing after years of resistance, but brushed aside calls for immediate action to shore up southern Europe and avert a Japanese-style deflation trap.
Mario Draghi, the ECB’s president, said the governing council had agreed unanimously to take emergency measures if inflation falls too low, a crucial signal that Germany’s two members will back the plans under certain conditions. “There was a discussion of QE: it was not neglected,” he said.
Yet the bank left interest rates on hold at 0.25pc and once again delayed cutting the deposit rate below zero, a step already taken by Denmark to boost lending and deter capital inflows.
Inflation fell to 0.5pc in March, the lowest since the financial crisis in 2009. It is below the 1pc level deemed to be the “danger zone” by Mr Draghi himself, yet the ECB has held five consecutive meetings without taking any further measures. This has allowed “passive tightening” to run its course as the euro rises.
“The ECB is playing with fire by failing to act,” said Ashoka Mody, former head of the International Monetary Fund’s rescue mission in Ireland.
Related Articles
Draghi gently puts IMF's Lagarde in her place 03 Apr 2014
ECBs deflation paralysis drives Italy, France and Spain into debt traps 02 Apr 2014
Brazil at risk of recession as S&P downgrades debt 25 Mar 2014
Capital controls feared in Russia after $70bn flight 24 Mar 2014
Putin's Russia caught in US and Chinese double-pincer 26 Mar 2014
Ukraine bail-out gives Russian banks a windfall 27 Mar 2014
Britain’s Healthiest Company: the wellness initiative no employer can ignore Pru Health
“Europe faces an extremely serious problem and the window is basically closing for the peripheral economies. The inflation rate in Italy and Spain is now so low that it calls into question their ability to service their sovereign debts. They need to 2pc inflation to make it,” he said.
The IMF’s Christine Lagarde said this week that the world in in danger of a “low-growth trap” and called on the ECB to step up to its responsibilities. “More monetary easing, including through unconventional measures, is needed in the euro area," she said.
Repeated criticism from the IMF is ruffling feathers in Frankfurt, where the ECB’s hardliners view bond purchases as a covert rescue for countries that live beyond their means. "The IMF has been very generous in its suggestions on what we should do," said Mr Draghi in a sarcastic tone.
Mr Draghi admitted that the ECB was caught off-guard by the sudden dip in inflation last month but insisted that the figures had been distorted by the timing of Easter. Inflation is expected to rebound in April and climb back slowly towards the bank’s target of 2pc by late 2016.
Lars Christensen, from Danske Bank, said Mr Draghi is trying to soothe markets and talk down the euro without doing anything. “The discussion over QE is meaningless when they haven’t even cut interest rates to zero or exhausted their normal tools,” he said.
“Unless there is a real change in monetary policy, the eurozone will head into deflation and a Japanese scenario. The longer they keep saying that a revival of inflation is just around the corner, the harder it will be in the end,” he said.
The euro fell half a cent to $1.3711 against the dollar after Mr Draghi spoke but currency analysts said the ECB will have flesh out its rhetoric with deeds to stop the euro rising further, already up 6pc in trade-weighted terms over the past year.
“Draghi is still not ready to pull the trigger,” said Hans Redeker, currency chief at Morgan Stanley. “It is going to take concrete action to force down the exchange rate. The eurozone has a big current account surplus and that means money has to be recycled out again just to stop the euro rising. This is what happened to Japan in the 1990s.
“The ECB has underestimated the disinflation dynamic in Europe for the past 18 months and we’re not yet convinced that they are on top of this."
Mr Redeker said European banks have repatriated $1 trillion from around the world over the past five years to shrink their balance sheets and beef up capital ratios, pushing up the euro yet further. These inflows continue.
Steen Jakobsen, from Saxo Bank, said the euro has already hit the pain barrier for Italy and France, among others. “Europe cannot survive for long at $1.40-plus. We’re pretty certain that even Germany will be flirting with recession by the end of the year.”
Mr Draghi must walk a political tightrope, biding his time as he gently cajoles the ECB’s German-led bloc to accept more stimulus. The Bundesbank’s Jens Weidmann appeared to drop his vehement opposition to QE last month but that does not end the dispute. Nor is it clear exactly what is allowed within the ECB’s mandate.
A recent ruling by the German constitutional court said the ECB’s bond rescue plan for Italy and Spain is a breach of EU treaty law and probably “ultra vires”, a term that would prohibit the Bundesbank from taking part.
While the ruling does not ban QE as such, it raises the political bar in Germany. The rest of the ECB has the votes to force Germany’s hand but any such move – if pushed too far – would violate the sacred contract of EMU that German sensitivities over monetary orthodoxy must be handled with care.
The Bundesbank may not be willing to act unless the eurozone is at imminent risk of full-blown deflation, but this may be too late. The IMF says that even chronic “lowflation” of around 0.5pc would cause the debt trajectories of Italy, Spain and even France to ratchet higher.
Marcel Fratzscher, head of Germany’s DIW economic institute, said prices in all three countries are falling for a third of the entire basket of goods. “The likelihood of deflation in the eurozone may only be 20pc but the costs are so enormous that it makes sense to take out an insurance policy,” he said.
Mr Fratzcher has called for €60bn-a-month of bond purchases across the board of all EMU states, roughly equal in scale to past actions by the US Federal Reserve. La Tribune newspaper, in France, reports that the ECB has been mulling a selective purchase of AAA bonds, chiefly German, Dutch and Finnish. This would set off a political storm in southern capitals.
Mr Draghi acknowledged that low inflation makes it harder for Club Med states to claw back competitiveness and sort out public finances. “The real value of the debt doesn’t come down as fast as it would,” he said.
Critics question whether it would down come at all. A study by Bank of America said lowflation would push Italy’s debt to 148pc of GDP by early 2018.
That is almost certainly beyond the point of no return for a state without its own sovereign currency and central bank. It may prove hard to justify austerity to voters for another four years if the policy is not even achieving its stated objective.