And now for something completely different?

The reflation trade is on but, to HSBC, the market reaction jars with the economic realities in Europe. 

Is ECB QE set to become an ‘ex policy’?
There’s more than a whiff of Monty Python’s famous parrot sketch in the ECB’s current position.
Like Michael Palin trying to persuade John Cleese that his dead parrot might be just “resting” or “pining for the fjords”, so the ECB for the past few years has been keen to convince markets that it has the will and the means to return inflation to target, despite mounting evidence to the contrary. It is two years since the ECB announced QE, albeit belatedly and cautiously. Yet inflation still seems stuck in a rut. So is ECB QE, like Monty Python’s parrot, dead? Is it an ex-policy? Is it time for something completely different?

The reflation trade is on and has spilled over to Europe …
Markets have become more optimistic on inflation and the reflation trade is on. Since Donald Trump was elected as the next US president, equities and bond yields have risen and the US dollar has appreciated. This positive sentiment has affected Europe. During Q4, ten-year bund yields rose from around -10bps to +25bps, and at 1.4% gilt yields are up around 90bps from their post-Brexit lows. European equities have shrugged off various political shocks to end 2016 at highs for the year.

… despite underlying inflation pressure remaining very weak
To us, the market reaction jars with the economic realities. The two key tailwinds to eurozone growth over the past two years – energy price deflation and fiscal headroom from falling government borrowing costs – have ended. We expect the eurozone to grow by just 1.2% in 2017 (see forecast table). This is 0.2pp higher than our previous forecast thanks to strong momentum going into the year, but it still marks a slowdown from 2016.
Unemployment and economic slack are still elevated in three of the eurozone’s big four economies and are likely to remain so. Credit growth remains lacklustre. There may be structural global factors, such as price-sensitive, digitally-savvy consumers restraining inflation. And the impact of monetary policy is still limited by a low ‘natural’ real interest rate. It will require more than a dose of US fiscal expansion to reverse the trend in the factors that have driven ‘natural rates’ down, such as slowing productivity growth, high debt burdens and unfavourable demographics.
In short, we think we are a long way from seeing ‘the whites of the eyes’ of sustained eurozone inflation. Core inflation in the eurozone is unlikely to rise much above 1% over the coming years, even if headline inflation is set to rise reasonably sharply. The 18% rise in the EUR oil price through Q4 2016 alongside EUR depreciation means we now see eurozone inflation peaking briefly at 1.8% and averaging 1.6% in 2017 (up from 1.0% previously). But we see core inflation reaching just 1.2% in 2018. Indeed, even after the latest extension of QE to December 2017, the ECB itself is only forecasting inflation rising to 1.7% by 2019.

The eurozone is unlikely to follow the US down the path of fiscal expansion
Markets shouldn’t rely on the fiscal expansion to drive up growth and inflation, even if there is a strong case for Europe to follow the US. In aggregate, the eurozone’s deficit, current account and public debt burden provide a more favourable base to launch a fiscal loosening. Also, there is an urgent need for investment, with the level of investment around EUR200bn below where it should be given the level of GDP. Even the European Commission has acknowledged this and requested (for the first time) an aggregate fiscal expansion of 0.5% of GDP. Unsurprisingly, it wants this to come from the surplus countries although it has no powers to enforce this.
This puts the burden on Germany, where the government was quick to rule out a large loosening of the purse strings. Age-related spending in Germany is set to soar over the coming decades, meaning it is not keen to give up its surplus. While the German government is likely to increase spending related to the influx of migrants and provide tax relief for households in 2017, no party will want to sanction fiscal expansion for purely European (and not national) issues in an election year. Moreover, Angela Merkel’s CDU has already made a renewed commitment to balancing the books if, as polls suggest, it is re-elected. Without Germany’s support (and money), meaningful fiscal expansion won’t happen.

This leaves the ECB in a tricky spot
The ECB is in a bind. It is failing to deliver its mandate and at the same time facing criticism from some quarters for keeping policy too loose. This criticism is likely to intensify as headline inflation rises through early 2017. If it continues with ever more QE, giving governments the means to provide fiscal support, it undermines the incentives to make the reforms it knows are necessary for it to achieve its inflation mandate in the long run. But if it stops buying government bonds, it risks a potentially catastrophic rise in government bond yields.

The effectiveness of QE to lift inflation may, like Monty Python’s parrot, be dead
Given the questionable benefit to solving the underlying inflation problem, there are good reasons to consider scaling back QE. Although QE has helped keep bond yields down and facilitated a looser fiscal stance, it has not succeeded in bringing inflation back to target. The sedative impact of QE on the market has dulled market signals, potentially causing an inefficient allocation of capital. It has allowed governments to delay fiscal consolidation and it has taken the pressure off making structural reforms, which are vital for increasing longer term growth.

So is it time for something completely different?
Perhaps the ECB’s best option to meet its inflation mandate is to accept lower inflation for a few years, ramp down its bond buying programme gradually and put the pressure back on governments to make structural reforms. To avoid a repeat of 2012, where reforms arguably contributed to a recession and the rise of populist parties, there would also need to be an investment-led fiscal stimulus that raises both near-term and, via higher future productivity, longer-term growth. This would require further steps toward centralised fiscal policy, after the raft of 2017 elections.
If future productivity and, in turn, longer-term real interest rates rose, this would make interest rates more effective as a stimulus tool. It could mean that inflation gets back to target in “the medium term” even if it remains low in the near term.

The ECB should reduce its purchases further at the end of 2017
In reality, the ECB is unlikely to administer a sharp shock. Mario Draghi has been clear that there will be no sudden stop to QE. However, we do think the ECB will reduce the QE purchase rate further when the current programme finishes in December 2017. Of course, the ECB may give different reasons for piling pressure on governments (eg higher headline inflation projections) but we think it is likely to announce another six-month extension, buying at EUR40bn per month, probably at its October 2017 meeting. And there is always the possibility of it adjusting its policy mix away from government bond buying to other forms of easing.

Politics and uncertainty have the potential to rattle markets in 2017
A bit of pressure on governments that forces them to take tough decisions to put the economy on a faster growth path could eventually do more to stem the rise of populist politics than shortterm, unsustainable giveaways. Overshadowing the entire 2017 European economic outlook are numerous political event risks. According to recent polls, the French presidential election will see the National Front leader, Marine Le Pen, contest (but lose) the second round run-off in May. We expect Italy to hold elections in Q2 2017, following the rejection of Matteo Renzi’s constitutional reforms in the December 2016 referendum. The German elections, which we
expect to be held on 17 or 24 September 2017, could see Angela Merkel elected for a fourth term if recent polls are correct, albeit with a reduced majority. Polls also indicate that the farright Alternative fu?r Deutschland could enter the Bundestag, potentially making the formation of a government more difficult. Concerns about unexpected results could rattle markets. Although the polls at the end of 2016 suggested the mainstream candidates would eventually prevail in the raft of upcoming elections, no-one is putting much faith in them after the UK’s EU referendum and US election results.
UK economics and politics are likely to be dominated by a single theme in 2017: Brexit. With the two-year Article 50 withdrawal process set to begin at the end of Q1, and several of the big EU countries focusing on their own elections, time will be short. The key judgement is whether uncertainty about the UK’s future will start to weigh on economic activity or whether businesses and households will simply keep calm and carry on, as they did in H2 2016. Our view is that uncertainty will depress business investment and higher inflation will slow consumer spending. Indeed, even without the added uncertainty of Brexit, the length of the consumer expansion, alongside the historically low savings rate, suggests that the UK could be overdue a consumer slowdown.

Simon Wells – Chief European Economist – HSBC Bank plc
Fabio Balboni – European Economist – HSBC Bank plc