Japanification: ECB to cut deposit rate this year, chances of QE restart seemingly high

The European Central Bank is more likely to cut the deposit rate this year in an effort to move the stubborn inflation, which the central bank failed to push decisively higher despite unprecedented stimulus.

While euro zone inflation remained below the central bank’s target for most of the time since late 2012, the ECB confidently halted the quantitative easing programme in end-2018 on hopes that ventilated inflation showed gradual signs of improvement and there was no fear of serious deflation.

But with the drop in the headline inflation rate to 1.2 percent in the year to May, down from April 1.7 percent, fear that the central bank is failing in its inflation mandate resurfaced, which increased speculation among economists that the ECB will restart quantitative easing.

Now the fear is that the ECB is left with limited ammunition to fight the next economic downturn after lowering the interest rates to record lows and swelling the balance sheet to over 5 trillion dollars.

“For the past eight years of his presidency, Mario Draghi has shown an impressive determination to act. Nothing is worse than a central bank admitting it has run out of options. In this regard, besides a possible rate cut, restarting the QE looks as though it'll be the most likely option. Even though a restart of QE would fall into the category 'more of the same', we would be very cautious calling Draghi an emperor with new clothes,” said Jeroen van den Broek, head of DM strategy and research at ING.

“In fact, in our view, the emperor is not naked at all; he has corporates, and banks, in CSPP2.”

Early this week, President Mario Draghi shocked markets by saying the central bank would cut interest rates or purchase assets if inflation in the euro zone fails to accelerate and continues to remain below the target.

His criticism apprehended the continual decline in inflation expectations that questions the ECB’s ability to achieve its target of 2 percent with a drained-well by years of monetary stimulus.

“Draghi seemed to indicate that his preferred order of policy response is further adjustments to the central bank’s forward guidance, cuts to the policy rates and additional QE, possibly with a preference for a deposit rate cut,” said Oliver Rakau, chief economist at Oxford economics.

The ECB is not the only victim fighting low inflation; the world’s biggest economy, the United States, inflation expectations is suffering from low inflation disease. Along with this, the global economy also slowed to its lowest in the past three years.

With that double body blow, the risk of a Japanification poses further threat to a slowing world economy. Japan’s desperate efforts to pull the ailing economy out of the pit presents a warning to other economies such as the euro zone, signalling the depth of stimulus measures thus needed.

“The eurozone has avoided some of the early policy errors made by Japan and taken a number of steps to tackle ‘Japanification’ risks. But productivity growth has flagged even more than Japan’s in the 1990s, and parts of the eurozone still risk sliding into deflation if the global downturn worsens,” said Adam Slater, lead economist at Oxford economics.

“The eurozone’s policy options to fight ‘Japanification’, particularly at the individual country level, are more limited than was the case in Japan. Further ‘heavy lifting’ by the ECB would be required – implying downside risks for the euro and bond yields staying low, if not compressing further.”