The ECB Needs an Inflation Plan, Just in Case

(Bloomberg View) -- Nearly three weeks after the European Central Bank halved the pace of its monetary stimulus to the euro zone economy, something strange is happening in the sovereign debt market.

Even as the ECB takes a little step back from quantitative easing, investors are continuing to pile into government bonds, particularly from some countries that were most affected by the crisis. The risk is that markets may be in for a rude awakening.

The cases of Italy, Spain and Portugal best represent this trend. The Italian 10-year bond yield has fallen by 20 basis points to 1.82 percent since the ECB announcement. The interest rates on similarly dated Portuguese and Spanish debt have decreased, respectively, by 30 and 11 basis points, to 1.95 percent and 1.52 percent. True, the ECB has extended purchases to September, and has left it open what it intends to do next. Even then, however, this does not look like the reaction to a monetary tightening.

Last week, in an interview in Rome, I asked Vitor Constancio, the ECB vice president, what he made of the reaction to the bank's tapering announcement. He first interpreted this as a sign of confidence in the euro zone economy.

"Everyone is now expecting that growth will continue,” Constancio told me. "Only an extraordinary international event could derail the continuation of the current significant growth path. That changes prospects for everything, and it perhaps provides an explanation for why markets reacted the way they did."

There is little doubt that the economic outlook for the currency area has improved substantially in recent months. The International Monetary Fund believes the euro zone will grow by 2.1 percent this year, up from 1.8 percent in 2016. All member states are taking part in the recovery, with differences in growth rates among the countries now much narrower than in the past. This makes sovereign debt in the euro zone periphery attractive, especially in a world of very low interest rates.

The trouble with this explanation is that it does not fit with what normally happens to the bond market in the event of a positive growth surprise. In theory, investors should demand higher interest rates to compensate for the possibility of higher inflation in the future. This is the opposite of what we have observed.

Constancio explains this apparent contradiction citing a favorite argument for central bankers: the "mystery" of missing inflation. In the euro zone, prices rose by 1.4 percent in the year to October, less than the ECB’s target of just below 2 percent. He says this is not just a euro zone phenomenon, but one that is also going on in the U.S. In fact, what is happening across the Atlantic may well be spilling over to Europe.

"In the markets, what prevails, also in the U.S., is that there is a very subdued view about future inflation," Constancio said. "That has also happened in our markets, with yields going down."  He added:

We also saw that the slope of the yield curve in the U.S. touched the lowest level since many years ago. Markets don’t expect in the short run inflation and nominal growth going up significantly, and that explains their reaction. That’s the way they see the future. It is important for us to really take that into consideration. 

How exactly should the ECB take this into consideration, though? The central bank obviously sets its monetary policy on the basis of what it believes will happen to inflation, not to the bond market. Still, so far, the ECB has been skillful in communicating its intentions to investors: This has avoided a disorderly reaction, even as the central bank was taking a first step back from quantitative easing.

But what would happen were inflation to begin to surprise on the upside? Right now, investors seem unprepared, meaning calm could easily turn into chaos. However remote this risk may seem at the moment, the ECB should start thinking about how to deal with it. Sudden shifts in monetary policy are the hardest to communicate.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Ferdinando Giugliano writes columns and editorials on European economics for Bloomberg View. He is also an economics columnist for La Repubblica and was a member of the editorial board of the Financial Times. 

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