Why Prices in Europe continue to sink?

Mario Draghi’s reasons for flooding the euro area with money will be laid bare once again this week.

Days after the European Central Bank president announced a 1.1 trillion-euro ($1.2 trillion) stimulus plan, data may show prices in the euro area are falling at close to the fastest pace since the shared currency was introduced 16 years ago.

Sinking prices, together with stubbornly high unemployment, will reinforce the picture of economic weakness that convinced the Frankfurt-based central bank to go ahead with the controversial purchase of government bonds. Anticipation of more action from Draghi to prevent a deflationary spiral lifted German business confidence this month and may be echoed in a euro-wide sentiment index on Thursday.

Europe’s QE Quandary

“We’re seeing a moderate recovery, but the big question is, is it strong enough to get inflation back up over the relevant time horizon?” said Nick Kounis, head of macro research at ABN Amro Bank NV in Amsterdam. “It helps the story if things start to move a bit more in the right direction and then he can get another round of Super Mario credit.”

While the ECB’s decision to start full-blown quantitative easing was widely anticipated, the size of the program exceeded forecasts. With monthly purchases of 60 billion euros until at least September 2016, the total was double economists’ projections.

Even with that scale, it’s unclear whether the stimulus will be enough to push inflation back toward the ECB’s goal of just under 2 percent.

Internal Models

Professional forecasters surveyed by the ECB before the QE announcement saw price growth of 0.3 percent this year and 1.1 percent in 2016. The bond-buying program is seen adding 0.4 percentage point and 0.3 percentage point respectively, according to a euro-area central bank official who has seen the ECB’s internal calculations.

In a Bloomberg News survey of 38 economists, the median forecast for January is for prices to drop 0.5 percent from a year earlier. That would follow a 0.2 percent decline in December and mark the second-biggest decrease since the creation of the euro in 1999. The record drop was in the depths of the recession, when prices fell 0.6 percent in July 2009. The data will be published at 11 a.m. in Luxembourg on Friday.

A separate report will show that unemployment in the region held at 11.5 percent in December, still near its record high of 12 percent. Persistently high joblessness, along with a backlash against austerity, was one of the key factors behind the victory of the Syriza party in elections in Greece on Sunday.

German Prices

Germany’s statistics office will probably report on Thursday that prices fell an annual 0.2 percent this month. That would be the first negative inflation rate in Europe’s largest economy for more than five years. In Spain, prices plunged 1.5 percent, according to a survey before data on Friday.

“Inflation is expected to remain very low or negative in the months ahead,” Draghi said at a press conference on Jan. 22. “Such low inflation rates are unavoidable in the short term, given the recent very sharp fall in oil prices.”

ECB Executive Board member Benoit Coeure said in a Bloomberg Television interview on Friday that QE could be expanded or extended if the impact on inflation isn’t judged enough. Governing Council member Ignazio Visco said the ECB is “open-ended” about asset purchases.

Confidence Rising

Crude oil has fallen by more than half from a peak in June. While that’s pushed down inflation, it’s also lowering costs for companies and consumers and may help stimulate the region’s economy.

The Ifo institute’s German business confidence index rose to 106.7 from 105.5 in December, improving for the third consecutive month. Euro-area economic sentiment may advance to a six-month high.

“The message from the ECB that it will do whatever it takes to deliver price stability may be very important,” David Mackie and Malcom Barr, economists at JPMorgan Chase & Co. in London, wrote in a note. “It looks as if the ECB stimulus has come at the precise time that the euro-area business cycle is making a turn upwards.”

Still, growth in the region may remain sluggish. Economists in Bloomberg’s monthly survey predict 0.3 percent expansion this quarter and next after 0.2 percent in the last three months of 2014.

“Draghi has given himself at least until September 2016 for the program to generate any effect,” Teunis Brosens, an economist at ING Bank NV in Amsterdam, said in a telephone interview. “The ECB is in it for the long haul here.”

Source: Bloomberg