Falling inflation prompts ECB action according to Bank of Ireland economist

Rates to remain at “present or lower levels for extended period”

The Euro area economy returned to growth in the second quarter with real GDP increasing by 0.3%, while the available data suggest output has continued to expand at a modest pace over the second half of the year. However, GDP at the end of 2013 is likely to be still more than 2.5% below its pre-crisis peak in early 2008, while the unemployment rate continues to rise, reaching a record high of 12.2% in September“, according to Bank of Ireland’s November Bulletin which was published today, Thursday 14 November 2013.

Commenting, Michael Crowley, Senior Economist, Bank of Ireland Global Markets said:  “There is, therefore, a considerable degree of slack in the economy, and this is being reflected in an accelerating decline in inflation in the zone. The headline inflation rate has fallen by almost 2% points to 0.7% over the year to October, having declined by just 0.5% points over the previous twelve months, while core inflation has fallen by 0.7% points to 0.8% over the same period, having barely budged over the previous year. The upshot is that inflation is now running considerably shy of the ECB target of “below, but close to, 2%”.

A turnaround in energy prices has contributed to the deceleration in overall inflation – energy prices fell by almost 2% in the year to October having risen by 8% over the previous 12 months – but the decline in core inflation reflects the slack in the economy and the labour market. The appreciation of the euro over the past year has also dampened inflation in the zone.

“The ECB responded to the continuing fall in inflation by cutting its main interest rate by 25bps to 0.25% at this month’s meeting, though it left the deposit rate unchanged at 0.0%. It said the Euro area economy may now experience “a prolonged period of low inflation” and hence reiterated its forward guidance on interest rates, namely that it expects “the key ECB interest rates to remain at present or lower levels for an extended period of time“. The central bank, therefore, retains an “easing bias” in relation to monetary policy and so may cut interest rates again if warranted by economic conditions.

A further fall in inflation, or a reversal of the nascent economic recovery in the zone, would almost certainly prompt further ECB action, while the central bank will also be particularly sensitive to any renewed rise in the euro exchange rate given the already very low level of inflation. The euro fell against the dollar post the rate cut and at around $1.34 is well off its recent high of over $1.38. The possibility of further easing by the ECB may continue to weigh on the single currency, all the more so now that a Fed tapering of asset purchases is back on the table after stronger than expected US employment growth recently“, concluded Michael Crowley