In the euro zone and the US, inflation remains dangerously low and well below the 2 percent central bank targets. Inflation is not expected to pick up in the short term as weak global demand holds back global energy and food prices. With weak growth expected in Europe and recent disappointing economic data in the US, the risk of deflation remains high. As such, European and US central banks are likely to keep monetary policy loose for an extended period. Therefore, QNB Group expects short-term interest rates in the Eurozone and the US to stay low for longer than prevailing market expectations.
In the euro zone, annual inflation has stabilized at 0.8 percent in recent months. Core inflation (excluding energy and food) is low at 1.0 percent, energy price inflation is negative and food inflation is flat. The European Central Bank (ECB) expects inflation to be 1.3 percent over the next year. This alone gives the ECB reason to take policy action, but there are a number of additional factors that add further incentive. The ECB expects real GDP growth to be only 1.1 percent in the euro zone over the next year. Unemployment is high, stuck at around 12 percent, on average, with youth unemployment above 50 percent in some periphery countries. The euro has strengthened 6.7 percent over the last year against a weighted basket of currencies. Overall, all these indicators suggest a strong risk of deflation, which are likely to prompt the ECB to loosen monetary policy, possibly by a small cut in interest rates, quantitative easing or other measures to increase liquidity.
In the US, annual inflation picked up from 1.0 percent in October 2013 to 1.6 percent in January 2014. However, US inflation is expected to slow sharply to 1.2 percent in February as the impact of a sharp rise in gasoline prices falls out of the annual number and as core inflation continues to slow. The low inflation outlook and some indications that the US economic recovery may be weakening, raises the potential for another round of loosening of monetary policy by delaying the tapering of Quantitative Easing (QE).
The Federal Reserve (Fed) has shown firm commitment to QE tapering during early 2014, despite a soft patch in economic data, which has widely been put down to bad weather. However, this resolve may be easing as recent comments from the Fed chairperson, Janet Yellen, have indicated that QE tapering could be adjusted if the US economy weakens. Upcoming economic data releases in March and April should give a clearer picture on how much of the recent weak economic data can be put down to bad weather. We do not expect the picture to be clear enough for the Fed to postpone QE tapering at its next meeting on March 19, but by the time the Fed meets on April 30, there is some risk that the economic outlook could have deteriorated enough to warrant a slowdown in the pace of QE tapering (the first reading of GDP growth in Q1, 2014 is also released on April 30) to offset the risk of deflation.
The potential for falling inflation in the Eurozone and US will make central banks wary of falling into a deflationary trap. According to economic theory, deflation fuels expectations that prices will continue to fall, encouraging delays to purchases, thus holding back growth (Japan’s experience in the last two decades is a good example). It also increases the real value of outstanding domestic debt, thus making it more difficult for borrowers to make repayments. Deflation also tends to lead to a stronger exchange rate, undermining competitiveness and growth. On the other hand, a moderately inflationary environment reinforces expectations that prices will continue to rise and encourages spending, borrowing, growth and a more competitive exchange rate. For these reasons, central banks tend to use monetary policy to target moderate annual inflation of around 2 percent, thus avoiding the perils of a deflationary trap.
Looking ahead, the risk of deflation and weak economies in the US and euro zone, present a strong case for the Fed and ECB to loosen or refrain from tightening monetary policy. This implies that any increase in short-term interest rates in the euro zone or in the US is still some way off. Qatar’s policy rates tend to track rates in the US owing to the pegged exchange rate. Therefore, interest rates are also likely to remain low in Qatar. A pause in tightening monetary policy in the US would have the added benefit of bringing greater stability to global financial markets. The implementation of QE tapering has led to capital outflows from a number of emerging markets, weakening their currencies and driving down asset prices. Delayed QE tapering could help bring greater stability.