Economic Projections For 2017: What If Europe Starts Raising Interest Rates?

by: John M. Mason


The latest inflation data from the eurozone indicate a substantial jump in inflation for December raising calls, especially from Germany, that the European Central Bank raise it's policy rate.

Inflationary expectations have jumped up in Europe and along with rising inflationary expectations in the United States, the picture is being painted of further increases in interest rates.

Most economic projections for 2017 do not include this kind of picture for inflation, inflationary expectations, and higher interest rates, further clouding an already clouded picture of the coming year.

The headlines read "Soaring Eurozone Inflation Presents ECB With Dilemma."

Seems that the year-over-year inflation rate in the European Union has jumped up to 1.1 percent for December 2016.

In Germany, the economic leader and champion inflation fighter of the eurozone, the inflation rate stands at 1.7 percent.

The European Central Bank has an inflation target of 2.0 percent, but ECB policy-making in the past several years has been dominated by the slow economic growth being experienced by the community and by the actual fear of deflation.

As is well known, the eurozone area has been faced with negative interest rates during this time.

The yield on the 10-year German bund had been traveling in negative territory since late June 2016, and especially tumbled into negative territory after Great Britain voted to "leave" the European Union. This yield mostly remained in negative territory until early October, and has been in positive territory since. The yield has gone as high as 40 basis points in the middle of December and closed yesterday at 18 basis points.

The possibility of higher rates of inflation have already resulted in calls for the ECB to back off from its quantitative easing stance and really consider raising its policy rate of interest.

It has been reported in the Wall Street Journal that inflationary expectations have risen dramatically in European markets.

"In the eurozone, the five-year inflation swap rate reached 1.77 percent Wednesday, up from a low of 1.25 percent in the middle of last year. This derivative tracks investors' bets on what the inflation rate will be starting in five years and lasting another five."

Inflationary expectations have also been rising in the US. This is measured by the difference between the yield on nominal 10-year US Treasury notes and the yield on 10-year US Treasury Inflation Protected securities (TIPS).

Inflationary expectations, measured in this way, were at 2.02 percent at the close of business yesterday. In late June 2016, inflationary expectations were under 1.40 percent. Note that just before the US presidential election in early November, inflationary expectations were still below 1.70 percent.

The jump in inflationary expectations here was due to the optimism that Trump economic policies of tax relief, deregulation, and infrastructure spending would put a "bounce" into a moribund economy. And, this optimism has been translated into the rise in the stock market since the election.

The problem has been in the US and in Europe that a lot of money has been pumped into their economies through the central banks in each area conducting policies of quantitative easing.

In the US, the Federal Reserve System went through three rounds of quantitative easing before backing off in October 2014. Since that time, the Fed has reduced the amount of "excess reserves" that exist within the banking system, but on December 28, 2016, there were still $1,943 billion in reserve balances with Federal Reserve banks, a proxy for "excess reserves." It should be noted that before the financial crisis, say, on September 12, 2007, these reserve balances totaled just $25 billion.

A concern here is that Trump fiscal spending could result in the commercial banks "letting go" of these excess reserves, a lot of things could happen on the inflation side.

In Europe, the European Central Bank has been dealing with its own quantitative easing and the extension of its buying of securities. Here the "monetary hawks" are concerned with the economies of the EU picking up, inflation getting up into the ECB's target range of 2.0 percent, and the current OPEC deal sticking which would cause oil prices to show a substantial rise causing consumer inflation to pop through the 2.0 percent range and go even higher.

Thus, the call for the ECB to back off of quantitative easing and begin to push policy rates of interest back up.

One of the reasons given for the slow economic growth and the lack of consumer inflation has been the feeling that Europe and the US have been dominated by the financialization of the economy and the financial engineering that has come to dominate business decisions.

That is, the funds that the central banks have injected into the financial system have gone more into the financial circuit of the economy, building up profits for investment banks and real estate operators that have purchased foreclosed properties, and less into the industrial sector of the economy where production and employment would be stimulated.

The rise in the stock markets and the increase in inflationary expectations appear to be connected with optimistic hopes that these funds going into the financial circuit will be re-directed into the industrial circuit of the economy producing faster economic growth, more inflation, and more jobs.

This scenario, however, raise concerns.

What if the European Central Bank now starts to consider reversing itself and begins to raise its policy rate of interest? What kind of pressure might this put on the Federal Reserve System? This is not what is built into most projections for European and US economies for 2017.

In other words, the performances of the European economy and the US economy are nowhere close to a sure thing right now.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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