Expert Commentary

Lagarde's Deflation Problem

As the ECB reviews its methods, pressure is growing for it to stop the deflation of interest rates.

Well, that's it then. The European Central Bank is embarking on its grand review of everything, from its price inflation target to the impact of climate change on its policies, and it's expected to be concluded at the end of the year. With the U.S. presidential election not until then either we can all just kick back, put our feet up and relax for the next few months. Yeah right. Markets don't work that way. Markets look forward in time and anticipate the future because that is what each individual participant is betting on every day. So don't expect markets to be quiet until November.

The market's main focus with regards to the ECB review is going to be whether it changes its goal of targeting annualized price inflation "close to, but below, 2%." So get ready for months of inane debate as to whether someone's speech or interview is suggesting that the target will get rid of the "but below" element, or whatever. Moving a few words around might be akin to rearranging the deckchairs on the Titanic. The market is aching for bold, decisive action and, as always, it will probably be the market itself that pushes the ECB into such a shift.

Perhaps that seismic shift will be to reverse the policy of negative interest rates. Although it's not our preferred, nor the proper, definition of deflation, one could say that, given that the interest rate constitutes the price of money or credit, the fact that the ECB has been hell-bent on reducing its benchmark rate below zero and keeping it there means that it has, itself, been one of the main proponents of price deflation. However, as we have pointed out previously, some of Irving Fisher's old economic work could be gaining momentum to encourage policy makers to actually increase interest rates as a way of generating price inflation which is what the ECB want a bit more of.

But maybe it will be the decimation of the European banking sector that finally encourages the ECB to abandon its negative rate policy. Last week, the heads of Deutsche Bank, UBS and ABN Amro all ripped into the policy with Christian Sewing of Deutsche Bank criticizing the ECB for "missing the exit" on negative interest rates, saying that it should have been done when the economy was recovering after the Eurozone crisis. Banks' profitability is severely reduced under negative rates and, as our Elliott wave outlook has been predicting for years, the trend for the European banking sector remains down.

Perhaps the ECB will have a lightbulb moment and take bold, decisive action in announcing an end to negative rates. But don't bet on it. More likely is that it will only reverse the policy when European banks start going bust.

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