The ECB Switches Into ‘Red Alert’ Mode

from Sprout Money Now it has become increasingly obvious the European economy is stuck in an extremely dangerous deflationary spiral, ECB president Mario Draghi is getting sweaty hands. It has now been four months since he unveiled his new Bazooka plan of 1000 billion Euros of which approximately a quarter has already been deployed. Despite pumping several hundred billions in the financial system, the inflation rate keeps on going down and has now reached negative territory in the Eurozone in December.

Euro InflationSource

This is an alarming fact and whilst the situation could be resolved there’s absolutely no time to waste as only a short period of deflation could be corrected. If the deflation persists for a longer period of time, consumers definitely will get aware of the consumer prices becoming cheaper and cheaper and thus refrain from buying anything more than they definitely need. This will decrease the amount of consumer spending causing the economy to contract even further, leading to stronger deflation. You don’t have to believe us, just ask Japan which is still trying to jump-start its economy after 20 years of deflation worries. As the take-up of the total amount of money made available for the banks was much lower than anticipated, Super-Mario has to find other solutions to pump additional liquidity into the financial system of the Eurozone. According to several sources, the ECB has now several plans on the table to purchase half a trillion Euro worth of government bonds from countries with a sovereign rating of at least BBB-. Most of the policy makers at the ECB seem to be backing this proposal but one can expect Germany and Austria to fight against the idea as both countries seem to be against any huge purchase of government bonds as that would reduce the incentive of the governments to tackle their budget problems. There are however pro’s and con’s to both parts of the problem. A low inflation rate is obviously bad news for the ECB and Eurozone countries which would like to see their sovereign debt being inflated away. However, a low inflation rate results in a low interest rate which makes it easier for countries to sell sovereign debt at a cheap rate.

Spain 10 year bond rate

Spain’s 10Y government bond rate Source So a low inflation rate might be bad for the economy as a whole, but governments aren’t really to alarmed about it. If we would for instance use Spain as an example, every 1% change in the sovereign debt yield results in a change of 12.5B EUR per year in annual interest payments. A 3% change thus results in the Spanish government saving 37.5B EUR in interest expenses. This might lead the ECB to (temporarily) let go of its inflation target of 2% and instate a ‘primary’ target of around 1% as that would reduce the risk of Eurozone-countries getting choked by a sudden rise of interest rates. The next meeting of the board of the European Central Bank is planned for January 22nd, and it wouldn’t surprise us to see the first batch of measures being implemented right after that meeting.

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