ECB QE extension likely, raising inflation will take time

Mario Draghi said last Thursday that the governing council did not discuss extending the QE programme this month. Raising inflation towards the ECB’s target will take time.

ECB QE raising inflationThe ECB is likely to extend its quantitative easing (QE) programme beyond its scheduled end-date of March 2017, and therefore will have to adjust the limits on bond purchases to materially boost the inflation outlook in the eurozone, Fitch Ratings analysts said. Raising inflation towards the ECB’s target will take time.

ECB President Mario Draghi said last Thursday that the governing council did not discuss extending the asset purchase programme this month, although the bank will examine how to ensure that sufficient bonds are eligible for the programme. The ECB left its main refinancing rate and deposit rate unchanged.

The ECB’s QE programme reached EUR1tn in early September 2016, with the majority of bonds purchased being sovereign bonds. However, the smooth operation of the programme, which has driven ultra-low yields across the yield curve, and the gradual recovery in eurozone growth, inflation remains well below the ECB’s target of below, but close to, 2%. There is little evidence so far that QE has helped to attain higher inflation.

For example, underlying inflation pressure, calculated from short-term core inflation indicators, remains very weak because of the lack of domestic price and wage pressure. We forecast eurozone inflation will rise to 1.1% at end-2016, but this expected pick-up will only reflect favourable base effects. Longer-term inflation expectations (5-year/5-year forwards) in financial markets are at historic lows (1.3%), and are lower than in January 2015 (1.5%), when the ECB announced QE.

Meanwhile other measures of inflation expectations, such as economists’ forecasts and surveys of non-financial market participants, point to a gradual increase in inflation but see it remaining below target over the next two years.

The economists therefore expect the ECB to clarify in the coming months its QE intentions for beyond March 2017. The ECB’s consistent willingness to loosen monetary conditions in response to disinflationary pressures is one reason we think the eurozone will avoid prolonged deflation.

However, the longer the period of low inflation, the higher the risk to inflation expectations, which ultimately could lead to the erosion of the ECB’s credibility. Falling wage dynamics are a warning sign that a new equilibrium of very low inflation remains a key risk to monetary policy.