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Some ECB Officials Fear Markets Losing Faith in Inflation Goal

Paul Gordon and John Ainger
Some ECB Officials Fear Markets Losing Faith in Inflation Goal

(Bloomberg) -- Fears are mounting at the European Central Bank that investors are losing faith in the inflation outlook, in a self-reinforcing spiral that could force the institution to dig deeper into its stimulus toolkit.

Staff at the euro zone’s national central banks are worried that inflation expectations are becoming “deanchored,” according to officials familiar with the matter. They cited bets on the outlook for consumer prices, which fell to the lowest on record this week despite the ECB extending its commitment to keep interest rates low and pledging to do more if needed.

That sentiment contrasts with a public denial on Thursday by President Mario Draghi that expectations are falling too much. An ECB spokesman declined to comment further.

Anchoring of inflation expectations is critical for a central bank, which stands to lose credibility if investors and consumers doubt its ability to reach its goal. That can increase uncertainty and damp demand, weakening the economy further and reinforcing the downward trend.

Some policy makers were already expressing their discomfort over the inflation outlook at their April meeting, yet expectations have dropped further since then. Moreover, differing comments at the Group of 20 meeting of finance chiefs this weekend in Fukuoka, Japan, suggested a lack of consensus over how the ECB should react.

The sagging market bets suggest investors believe Draghi has few tools left in the locker to get inflation back to the goal of “below, but close to, 2% over the medium term.” The ECB chief said further rate cuts and a resumption of bond purchases were discussed when the Governing Council met on Thursday in Vilnius, though other officials said those talks were theoretical and didn’t touch on specific scenarios.

Definitive Deanchoring

“Five-year, five-year forwards are 1.24% -- they hovered around 1.7% to 1.8% for most of 2017 and 2018,” said Patrick Armstrong, chief investment officer at Plurimi Wealth LLP. “That is the definition of deanchored.”

Subdued inflation has been a conundrum in the developed world since the global financial crisis, and the U.S. Federal Reserve is reviewing its own strategy. Such concerns have been heightened by slowing international growth amid trade tensions, prompting central banks around the world to turn dovish.

Senior ECB policy makers have publicly pushed back against the idea of deanchoring, noting the wider trend and stressing that market-based measures are affected by heightened global risks. Executive Board member Benoit Coeure, responsible for market operations, downplayed concerns in a speech in March, and Draghi addressed the topic in his press conference on Thursday.

“There are, based on various analysis, no threats of deanchoring inflation expectations, but certainly there is a considerable mass of distribution between zero and 1.5% now. By the way, this fall, this slide in inflation expectations is not happening only in Europe; it’s also happening elsewhere, although admittedly from higher starting levels. So there must be some sort of global factor, but it’s certainly something that we take into account.”

-- ECB President Mario Draghi in Vilnius, June 6

Lithuanian Governor Vitas Vasiliauskas told Bloomberg on Friday that the ECB’s own inflation projection is “not bad” and it’s worth waiting to see if the economy picks up in the second half of the year. He called the market reaction to the press conference “surprising.”

Still, even if the market-based measure is distorted, central-bank officials are worried about the perception of deanchoring. Draghi may have to come up with something big in the five months before his term ends, or leave it to his successor. That’s another area of uncertainty as European Union leaders might not make a formal appointment for the presidency until after the summer, and the wide pool of candidates includes policy makers such as Bundesbank President Jens Weidmann, who has criticized past stimulus.

At the G-20 meeting, Weidmann reiterated his view that policy makers shouldn’t rush to put off plans to exit from ultra-low interest-rates. In contrast, Bank of Italy Governor Ignazio Visco said “we will certainly act” if needed.

The record low in market expectations “tells you all you need to know,” said Charles Diebel, head of fixed income at Mediolanum Asset Management, who sees a resumption of QE as possible. “That’s not close to, but below, 2%.”

--With assistance from Carolynn Look, Milda Seputyte and Jeffrey Black.

To contact the reporters on this story: Paul Gordon in Frankfurt at pgordon6@bloomberg.net;John Ainger in London at jainger@bloomberg.net

To contact the editors responsible for this story: Paul Gordon at pgordon6@bloomberg.net, David Goodman, Brian Swint

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