The ECB and deflation

Deflation concerns are at the top of the agenda this morning, as the ECB prepares to issue its latest rate decision.

Flash CPI for March came in below expectations at 0.5%, boosting the argument of those that see the eurozone as sailing dangerously close to deflationary waters. This reinforces what Mario Draghi said at the last press conference; namely that the strengthening euro only gives more impetus to the disinflation spiral.

Consumer prices (lack of) growth

Central banks around the world are battling with low inflation, but the danger is perhaps more acute in the eurozone than in any other major economy. The European Central Bank’s target is still 2%, so we are running at only a quarter of what CPI should actually be.

Price growth is now at its lowest level since March 2009 in the eurozone and, when adjusted for austerity measures, some argue that prices have actually dropped by an annual rate of around 1.5% over the past five months. And yet the ECB still seems set on doing nothing. Dovish words has been its weapon of choice, but this has clearly had little impact over the past few months.

Meanwhile, other economic data has hardly been particularly encouraging. Some manufacturing PMIs have edged higher, but Germany’s has dropped back. Meanwhile, services data showed worrying contraction in the eurozone as a whole, and in Germany too.

Then there is the cost of borrowing. Portuguese 10-year yields (how long it seems since they were the constant focus of attention) are below 4% for the first time since early 2010, and Spanish 10-year bonds are back in the headlines too after they dropped to a near ten-year low. Declining yields raise the possibility that the ECB will have to start a bond buying exercise to stave off deflation.

Developments in the government bond market have been sufficient to tempt Jens Weidmann, governor of the Bundesbank, to come out in tentative support of a bond-buying exercise if it began to endanger the fledging recovery in the eurozone.

This would be tantamount to quantitative easing, however it would run contrary to the ECB’s mandate. The bank is therefore in a dilemma, but with little room to cut rates from their present lows (and considering that the effect of the previous rate-cut has now been firmly dissipated) the pressure to do something is building.

EUR/USD outlook

Ahead of the meeting today, $1.38 remains the level to watch. The move back from above $1.39 was rapid, indicative of a rally that had gotten ahead of itself.

However, EUR/USD continues to hold above the 50-day moving average, which has been the case since mid-February. So long as this holds then the price action looks likely to tend to the upside, so long as $1.38 is broken in due course.

A break below here would throw open the possibility that we will see $1.37, which is where the 100-day moving average currently resides. Mr Draghi needs to maintain his positive outlook for the currency union, but with each day it becomes more and more difficult to imagine a eurozone recovery if the currency continues its upward trajectory.

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