The eurozone’s economic problem is too little inflation. Inflation has undershot the European Central Bank’s (ECB) target of 2% since 2013, and the ECB staff’s current inflation forecast of 1.7% for 2017 looks unrealistic. Without additional measures from the central bank, we think inflation in 2017 could be as low as 1.3%. Five years of below-target inflation (2013–2017) runs the risk inflation expectations permanently de-anchor – as witnessed in Japan – from the target. Additional stimulus, we believe, is therefore warranted.
Economic agents (market participants, decision makers) change their expectations in response to shocks. The risk, from a policy perspective, of a tepid (less shocking) ECB response is that it becomes the “new normal”, i.e., agents learn to believe the new policy is permanent without changing expectations. It is arguably more effective therefore to act quickly with force rather than drag out the policy response.
With this in mind, our baseline for the ECB’s Governing Council meeting on 3 December is that it will endeavor to shock inflation expectations upward by credibly promising to behave irresponsibly. Doing so will entail both increasing the quantity of asset purchases and cutting interest rates.
We think the Council will increase monthly asset purchases from the current €60 billion to about €70 billion, effective January 2016, and extend this pace to at least March 2017. The ECB’s expanded quantitative easing (QE) programme, which will probably be dubbed QE2, could end up adding an additional €500 billion of asset purchases on top of the original €1.14 trillion the ECB already intends to purchase. Together, this will amount to about 15% of eurozone GDP. Adding bonds from local governments and their agencies will facilitate achieving QE2.