The Meaning of the Decline in the EMU’s Core CPI

The eurozone reported a flash reading of its October CPI today, the last day of the month.  After softer Spanish and German national reports, it was not surprising that the headline eased to 1.4% from 1.5%.  ECB President Draghi has warned of some near-term softness due to energy prices.  

The unexpected news was that the core rate slipped back to 0.9% from 1.1%.  This matches the low from May.  The low this year and last was 0.7%, while the cyclical low was 0.6%.  

To be sure, the ECB does not formally target the core rate.  Nevertheless, it is operationally clear that it matters to policymakers.  It helps inform the judgment that inflation is not yet on a sustainable path toward the target, and is the primary reason why the ECB seemed unanimous in extending it asset purchases well into next year.

Draghi suggested that there was some disagreement on whether to leave the purchases open-ended or announce, that barring some new shock, an end date.  A newswire reported that there might have been five dissents from the decision to keep it open-ended.  This group of five represents the hawkish wing of the central bank.  It appears to be composed of central bankers from Austria, Estonia, the Netherlands, and, of course, Germany.

What is the difference between saying that the ECB intends to complete its purchases in September and saying simply the recalibration commitment runs to the end of next September?  Strategic ambiguity.  This is a concept from game theory.  Sometimes it may make sense to be clear, transparent and unambiguous.  However, those values are contextual and not moral or ideological.  They are tactics.

There are many times when being less clear and less obvious allows one to maximize the degrees of freedom and keep adversaries on edge.  There are numerous examples of this, such a the US refusal to rule out first use of nuclear weapons or Israel’s reluctant to admit it has nuclear capability.  This is to recognize that sometimes having an adversary be certain how one would respond may act as a deterrent.  On the other hand, making the adversary uncertain how one would respond also may have advantages.

It is difficult to test counter-factual claims, so let’s begin with what has happened since the ECB’s meeting last week.  Ten-year German and French yields have fallen 13-15 bp, while the yield on Italy’s benchmark is off 25 bp and Spain’s is off 19 bp.  There have been some other considerations that may have aided Italy, like S&P’s unexpected upgrade before the weekend, and the seeming end of the Catalan secessionist drive.  If the dissents had carried the vote and a hard end date was provided, would yields have eased as much?

There is no need to pre-commit.  The open-ended nature of the purchases maximizes the flexibility of decision-makers.  That was the basis of our argument last month that the ECB would reduce its purchases to 30 bln from 60 bln, while the consensus was for a move to 40 bln euros.  Our judgment was based on flexibility rather than a supposed shortage of securities, which Draghi continues to deny to reporters who seem to question him after every meeting.  The question has not changed, and neither have the answers.

Is tapering in Q4 18 from 30 bln a month to zero the difference between competent and incompetent management of monetary policy?  If buying more than 2 trillion euro of assets produced a certain response would topping it off with say another 60 bln euros make a significant difference?  We answer both questions in the negative.

Nevertheless, the dissent is important.  First, it offers a crystallization of a hawkish wing at the ECB.  They are the usual suspects (Germany, Austria, and the Netherlands). Hansson (from Estonia) comments had also shown his leanings.  There may be a one or two others that might side with the hawks but disagreed on this particular tactical issue. In the current environment, the hawks are a minority, but one who’s power and influence is arguably greater than its numbers.

Second, the dissents may not have been so much about the tactics of tapering.  The dissents were a proverbial shot across the bow.  It was a warning of the post-QE struggle for the soul of the ECB.  Will it revert back to the Bundesbank’s ordoliberalism, which Draghi said is part of the central bank’s DNA?  Or given the TLTROs that will be outstanding for several years, open-ended reinvestment of maturing proceeds, and the sheer size of the ECB’s balance sheet has the ECB’s DNA changed?

There has been much focus on the pending significant changes of personnel at the Federal Reserve’s Board of Governors.  Similar and profound changes are coming to the ECB, but they are more stretched out in time than the changes at the Fed.  In the middle of next year, the vice president’s term ends.  The choice here could paradoxically influence that the succession of President Draghi in 2019.  Also, in 2019 Praet’s and Coeure’s terms on the executive board of the ECB’s end.  That means in the four of the six executive board members will be replaced in 2018 and 2019.

Speculation of Draghi’s successor has already begun.   The Bundesbank’s Weidmann is an obvious candidate.  However, he has proven divisive and has testified against the ECB before the European Court of Justice.  The ECB President much be a consensus builder, and it is not clear that Weidmann is up to the task.  He has vigorously defended the Bundesbank, but even the German government reportedly did not support his appearance before the ECJ.

And thinking again about the counter-factual, the history of this period could have been markedly different if Germany’s Weber had succeeded Trichet as ECB President instead of quitting after losing a vote.  Germany’s Stark also resign then, and he may have been a candidate to succeed Draghi.  There does seem a to be a way to square the circle:  have a German at the ECB who is not a doctrinaire defender of the interests of the creditors.  Praet, the chief economist at the ECB, hails from Germany and is regarded as more of a team player.    Some may object based on age, but this is not necessarily a deal breaker.  We note that BOJ’s Kuroda, who may be given a second term, and Yellen, who is said to be under consideration of a second term are a little older than Praet.