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Draghi holds course despite deflation

Friday, March 14 12:12:41

Meeting students at the University of Amsterdam in April last year, European Central Bank President Mario Draghi extolled the virtues of courage, recalling a story his father had told him:

"In between the wars, he saw an inscription on a German monument, a German statue saying that 'if you lose your money you've lost nothing, because with a good business you will take it back; if you lose honour, you've lost a lot, but with good heroic action you can get it back; but if you've lost courage, you've lost everything.'"

Draghi showed his steeliness at the height of the euro zone crisis, vowing to do "whatever it takes" to save the currency.

Now investors would like him to show the same mettle again and take bold policy action to buoy the euro zone economy and steer it away from the economic quicksand of deflation. With no 'shock and awe' policy move in sight, they may be disappointed.

Draghi has shelved one bite-sized measure the ECB had discussed, essentially thinning its armoury to a "big bazooka" - U.S.-style quantitative easing that would be difficult for some ECB policymakers to stomach - or nothing.

The risk is that the ECB fails to act early and aggressively enough, and that a cocktail of downward cost pressures sucks the economy into a quagmire of falling prices.

So far, the ECB insists inflation expectations are sound, or "anchored" in central bank parlance, and there is no risk of deflation, which would lead households to defer purchases, crimping demand and entrenching a downward price spiral.

But the situation is fragile and could change quickly.

"You should not be over-reassured by the fact that expectations are still anchored, and I would add that when you find out that they are not anchored any more it may be too late," said Francesco Papadia, a former director general for market operations at the ECB.

The example of Japan, which has been mired in deflation for 15 years, offers a frightening precedent. Price declines there were so mild to start with it took a long time for the Bank of Japan to acknowledge that deflation had set in and that it was dangerous enough to require a strong policy response.

There are striking parallels between 1990s Japan and the euro zone's plight now: weak bank lending, fragile economic growth, a rising exchange rate, and the central bank's insistence that deflation is not on the horizon.

ECB Executive Board member Benoit Coeure, who speaks Japanese and knows the country well, warned on Thursday about banks rolling over bad loans, what he called "zombie lending", as they had done in Japan. "We've seen a risk of Japanification of the euro zone," he said in Paris.

There are some differences between the economies: with an ECB-led health check of its banking sector, the euro zone is being more proactive than Japan in cleaning up its banks. And there is no sign yet of European consumers deferring purchases.

"The situation in the euro area is different because inflation expectations are firmly anchored, whereas they were not in Japan," Draghi explained after the ECB's March 6 policy meeting in response to a question from Reuters.

The International Monetary Fund is more concerned and has urged the Frankfurt-based central bank to take action such as an interest rate cut or even quantitative easing.

Adam Posen, a former Bank of England policymaker who now runs the influential Peterson Institute for International Economics in Washington, also says the ECB should do more.

"Deflation ... doesn't move very much. When it gets low, it will stay low. We can see now how hard it is for Japan to move (inflation) up just a couple of percentage points. So the ECB is accepting too much risk of them getting stuck at where they are now," he told Reuters.

Draghi himself has warned of the risk of inflation becoming stuck in a "danger zone" below 1 percent.

ECB staff forecasts released last week showed euro zone inflation quickening from 0.8 percent last month to 1.5 percent in 2016, when it would hit 1.7 percent in the final quarter.

That would see inflation just about hit the ECB's target of "close to but below 2 percent" within its policy-relevant medium-term horizon. But inflation is notoriously difficult to forecast over longer periods.

"The experience of Japan is sobering here because nobody expected that Japan would have some 15 years of inflation bordering with deflation: our ability to forecast inflation over the medium-run is poor," said Papadia.

Andrew Bosomworth, a portfolio manager at Pimco, the world's largest bond fund, says a shock to the euro zone economy could easily blow the bloc's fragile recovery off course and send it towards deflation.

"Another negative external shock would certainly tip the scales," he said. (Reuters)