Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

European Deflation

The ECB has a specific section on its website titled 'benefits of price stability'. There are few benefits summed up such as the reduction of inflation risk premia in interest rates, and prevention of an arbitrary wealth distribution in case of unexpected inflation or deflation. The implied objective of price stability is to avoid a prolonged inflation or deflation. In that regard, the ECB renders transmission of price stability through one key channel, the policy rate. The change in the policy rate affects expectations which filters through asset prices, credit, and the exchange rate right down to the general price level. Figure 1 shows a schematic view of what the ECB sees as channels of monetary transmission.

Figure 1: The ECB's view of monetary transmission

Source: ECB

Past week's attention has been on inflation in the Eurozone. The headline rate fell back to new lows, levels not seen since the start of the monetary union. There is speculation the ECB may have to deploy quantitative easing after all. The immediate effect of such expectations has been on the Euro which fell by 1 percent to the dollar over the past few days. Although ECB may signal quantitative easing more strongly that it has done so far, it's reaction function--a Taylor like rule--suggests to follow a 'normal' policy rate. That means the ECB's policy rate implied by the Taylor rule is perhaps several still several 100 basis points too high because of the large output gap and high unemployment. With quantitative easing legally constrained, a negative deposit rate not really having an effect, and Targeted LTROs in effect by September, the only direct tools left for the ECB currently are forward guidance and the exchange rate.

In working papers, ECB staff has simulated what a one percent change in the exchange rate would have an effect on inflation and GDP. Taken from a 2007 study (Hahn/Wieland), inflation and GDP are impacted by about 0.03% to 0.15% for 1% change in the Euro currency. In absence of no other variables, to get inflation closer to 2% target from present levels (0.7%), the Euro would have to depreciate by at least 12%-15%. The ECB has titled its forward guidance 'qualitative' based on price stability. Given the low level of current inflation it would have to strengthen the guidance by signaling interest rates will remain low for a much longer time. Both the exchange rate and forward guidance (expectations) are variables in the ECB's transmission schematic of figure 1.

For the ECB to meaningfully impact inflation would be through a weaker currency without actually printing it. The way this is done is by strongly committing to reach 2% inflation over a shorter period of time while strengthening of forward guidance to keep rates much lower for much longer period. It is to be seen if the ECB is serious about such an commitment.