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Lagarde’s deflation dilemma: virus piles stimulus stress on ECB

The day after Christine Lagarde presents the European Central Bank’s newest financial coverage choice on Thursday, new figures are anticipated to indicate the eurozone sank into its third consecutive month of deflation — one thing it has completed solely twice earlier than.

The concern that Europe is turning into slowed down in a Japanese-style cycle of weak progress, unfavorable rates of interest and sub-zero inflation is anticipated to dominate discussions amongst ECB policymakers this week, even when they’re more likely to take no quick motion.

The gloomy pricing information on Friday will likely be accompanied by a uncommon piece of fine information for the eurozone, with gross home product figures anticipated to disclose file progress of near 10 per cent between the second and third quarters — bouncing again from a deep recession within the first half of this yr.

But these numbers already appear outdated, as a resurgence of coronavirus infections and tightening authorities restrictions — together with curfews in France, Italy and Spain — threaten to tug the 19-country bloc right into a double-dip recession. 

In response to the darkening outlook, Ms Lagarde is anticipated to sign clearly that extra stimulus is probably going in December.

The problem for the ECB president is that, with the eurozone sliding in direction of one other downturn and governments nonetheless bickering over the small print of the EU’s €750bn restoration fund, doubts are rising over the central financial institution’s means to tug the economic system out of the stoop.

“The problem is, the fourth quarter looks like being a disaster,” stated Lucrezia Reichlin, an economics professor on the London Business School and former head of analysis on the ECB. “We need to avoid the mistakes of Japan and that means doing more on both fiscal and monetary policy in a concerted way.”

Although financial coverage “has a very clear effect on reducing the spread [the gap in lending rates between riskier and safer borrowers]”, Ms Reichlin warned that “there is a big question mark over how much that translates into higher inflation”.

When Ms Lagarde was appointed to exchange Mario Draghi as ECB president nearly precisely a yr in the past, many commentators believed that her Italian predecessor had used up many of the ammunition within the central financial institution’s stimulus armoury. But since then the ECB has give you a number of new methods of injecting low cost cash into the economic system. 

First, it launched a €1.35tn emergency bond-buying programme that distributed with the self-imposed limits that threatened to limit asset purchases. Second, it agreed to simply accept bonds as collateral even when they have been downgraded beneath funding grade standing after the pandemic began. And lastly, it began lending cash to banks at charges as little as minus 1 per cent — the primary central financial institution to lend beneath the speed it pays on deposits.

These measures — together with an enormous fiscal stimulus launched by eurozone governments — have been extensively credited with stopping the pandemic from triggering one other debt disaster within the bloc.

However, the ECB’s essential goal is to realize worth stability, which it defines as inflation of near however beneath 2 per cent. It has did not hit this goal for years, regardless of shopping for trillions of euros in bonds and slicing rates of interest deep into unfavorable territory. Now economists warn that it appears additional away than ever earlier than.

The ECB is caught in a “lowflation trap”, in response to Athanasios Orphanides, the previous head of Cyprus’s central financial institution who’s now an economics professor on the MIT Sloan School of Management. “Since 2012, average inflation has been only 1.1 per cent.”

The ECB found fresh weapons to fight the pandemic

Others, reminiscent of Daniel Harenberg, an economist at Oxford Economics, imagine Ms Lagarde is going through “secular stagnation”. Anatoli Annenkov, an economist at Société Générale, stated: “Is monetary policy even working at this stage?”

Given the harm that the pandemic’s resurgence is more likely to do to swaths of the economic system, the ECB has admitted that deflation is more likely to final till early subsequent yr, when it hopes a reversal of German tax cuts will increase costs.

Such a chronic interval of deflation is unhealthy for an economic system as a result of it may possibly discourage customers from spending and companies from investing in the event that they imagine costs could possibly be decrease in future, whereas it additionally will increase the burden of reimbursement on debtors in actual phrases.

Recent surveys of eurozone customers and companies have all pointed to a pointy downturn in confidence and activity since coronavirus infections began hitting new highs in lots of nations this month. Another worrying signal for the ECB is that banks reined in their lending within the third quarter and stated they deliberate to tighten credit score requirements additional within the ultimate months of the yr.

The ECB’s forecast of three.1 per cent GDP progress within the fourth quarter appears to be like more and more unbelievable and Ms Lagarde is extensively anticipated to sign that extra financial stimulus is probably going except the outlook improves earlier than its subsequent rate-setting assembly in December.

However, if the central financial institution is to keep away from being trapped in a deflationary spiral, economists say it might want governments to offer much more fiscal stimulus.

“I think there will be a new bazooka from both the European fiscal and monetary sides by the end of the year,” stated Ms Reichlin. “They will have to keep on pumping with all that they have.”

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