As discussed earlier, the ECB could find it tricky to add further stimulus as inflation rises in the near term. Indeed, if former ECB President Trichet had been in charge, we wonder if he would raise rates! Fortunately, the governing council led by President Draghi seems to be more forward-looking now. The rise in energy inflation is likely to be temporary, even if oil prices continue to rise towards $70 p/b. Headline Eurozone inflation may approach 2% in the nearterm, but it should then fall back to well below what the ECB would consider as being adequate inflation. However, to make the communication of ongoing stimulus easier, we suggest the extension of QE should be announced sooner rather than later. We assume the announcement will accompany the new ECB
staff projections at the 8 December meeting.
As for the Bank of England (BoE), monetary policy has recently come in for some criticism from new Prime Minister Theresa May, blaming low interest rates and QE for contributing to inequality. Indeed, in her recent speech at the Conservative Party conference, she suggested that the government may need to intervene. Other senior party members also threatened the Bank’s independence if the current path of policy was to continue. This new political threat to the Bank
is a concern for investors.
Most believe that the UK will face a slowdown in growth as businesses pull back capital spending due to the uncertainty caused by Brexit. Moreover, the rise in inflation that we expect for the coming year will erode the purchasing power of households. As highlighted in the earlier section, real disposable household income growth was below 3% in the second quarter of this year.
Therefore, if wages do not rise with the pick up in inflation, households are very likely to cut
back spending in 2017. Therefore, while inflationary in the near-term, the fall in sterling and the rise in imported prices will be deflationary further out. The BoE has always targeted the medium term when targeting inflation; however, could inflation above their target in 2017, coupled with political pressure force the BoE’s hand in stopping QE sooner? For the moment, we assume the BoE will hold true to its beliefs and extend QE through 2017 and cut interest rates again
to 0.1% in November.
Meanwhile, expect the usual gyrations in markets from pricing deflation to pricing too much inflation. Higher break-even yields and steeper yield curves are arguably long over-due, but we should see both, if for only the first half of next year.
Azad Zangana, senior European economist and strategist at Schroders