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Thursday, 27 March 2014

Partiam, partiamo or the ECB communication

In the "Atto secondo, Scena IV" of Verdi`s opera, La Forza del Destino, there is a famous choir which keeps singing "partiam, partiam, partiamo" (let's leave, let's leave, let's leave) while remaining stubbornly on the scene, without making deeds follow words.

I cannot help recalling this scene while observing the communication from the ECB.

It is a few months, since November of last year when it last reduced rates, that the ECB is sending the message that it is ready to reinforce its action to symmetrically pursue its objective of "close but lower than 2.0% percent in the medium term", while not actually following up with action.

The pitch of the communication has been raising recently, with renewed "partiam, partiam, partiamo" utterances. These have attracted particular attention as they also came from the hawkish side of the Governing Council range of views. In particular, the President of the  Bundesbank has been interpreted as mollifying the opposition of the German central bank towards a European version of the FED's Quantitative Easing. On his side, the Governor of Suomen Pakki, Liikanen, whom I regard as the best approximation too the median voter in the Governing Council, has talked about the possible effectiveness of moving to a negative rate on the deposits of banks with the central bank. Sum this to the repeated statements of the ECB President about the importance of the exchange rate for inflation control and you sense that the choir has brought its singing to a higher plateau.

There are two possible interpretations of this development, not necessarily mutually exclusive.

The first interpretation is that the Governing Council is correcting the image of insouciance that it transmitted at the last press conference following the Governing Council meeting. Then the market was disappointed twice: first, because no new measure was announced, second, because it was not even mentioned that a serious discussion about a concrete measure had taken place. Under this interpretation, we would see a classical example of "open mouth" operations, mostly targeted at avoiding too buoyant an exchange rate. Given the elasticities mentioned by Draghi at his last press conference (10.0% exchange rate appreciation brings about 40 to 50 basis points reduction in inflation) a further, small exchange rate appreciation, say by 2.%, would be plausibly sufficient to bring inflation for 2016 down towards 1.4%, further away from the 2.0% ECB target. 

The second interpretation is that an agreement is maturing within the Governing Council to provide further assurance against too long a period of too low inflation (not to mention deflation) and that the choir is just preparing the market for that. Under this interpretation action would follow words before too long.

The way to reconcile the two positions is that some Governing Council members think that, at least for the time being, words are enough, while others are instead convinced that action should soon come.

Whatever the interpretation is, the new pitch of the choir is creating some market expectations. If these expectations will be, again, disappointed, whatever calming effect was obtained on the exchange rate will be lost and we could see further strengthening of the €, with the ensuing, undesired result of downward pressure on inflation.

The game with market expectations is further complicated by the fact that, by not acting last month when the new macroeconomic projections have been presented, the Governing Council clearly said that, in its judgment, four years of inflation around 1.5% are still consistent with its medium term objective of 2.%. On what basis would now the Council review its position and take new measures? The difficulty of behaving consistently is of course even bigger if more radical measures, like negative deposit rate or QE were to be considered. What has changed to justify moving from doing nothing to some radical action?

In conclusion, it is not easy to interpret current ECB´s communication. Of course, after much hesitation, the choir in La Forza del Destino eventually left the stage. Whether the Governing Council will follow its example remains to be seen.

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