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By HaleStewart February 6, 2014 12:48 pm
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Draghi and the European Central Bank Drop The Policy Ball

For the last several months, economists have been commenting more and more on the heightened possibility of eurozone deflation.  They have pointed to the nearly halving of the year over year inflation rate over the last 12 months as primary evidence.  Unfortunately for the EU, the latest policy announcement from the ECB indicates the bank is falling behind on this front.

Let's look at where Draghi gets it wrong by looking at the key phrase from his policy announcement

Underlying price pressures in the euro area are expected to remain subdued over the medium term. In keeping with this picture, monetary and credit dynamics remain subdued. At the same time, inflation expectations for the euro area over the medium to long term are firmly anchored in line with our aim of maintaining inflation rates below, but close to, 2%. Such a constellation continues to suggest that we may experience a prolonged period of low inflation, to be followed by a gradual upward movement towards inflation rates below, but close to, 2% later on.

While he correctly notes inflation is currently low, he makes the mistake of stating there will be a gradual upward movement towards" the 2% inflation level.

But what will drive inflation to this level?

It won't be producer prices, as these are now negative on a year over year basis, and have been for the last 5 months. 

 

Just as importantly, with China slowing down, there's downward pressure on commodity prices worldwide, add further fuel to the deflation pressures from the producer side.

Consumer demand is clearly muted as the continually negative year over year retail sales numbers show:

 

And with unemployment at 12% for an extended period of time, we shouldn't be looking for a pick-up in demand pull inflation anytime soon:

Ultimately, my guess is Draghi realizes the only real moves he has left are extraordinary measures such as a euro based QE program.  More importantly, if the ECB engages in this policy, they will be admitting the "growth is around the corner" story they've been telling is wrong.  But at the same time, it's clear the current policy just isn't working, nor is it appropriate.

Hale Stewart is a former bond broker who has been writing about economics and financial markets since 2006 on the Bonddad Blog.  He is also a tax attorney with a domestic and international practice while also forming and managing captive insurance companies for US companies.   You can follow him on twitter at:@captivelawyer

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