ECB confronts cheaper oil spilling onto stimulus debate

Mario Draghi and his colleagues are about to debate whether cheaper energy is a blessing or a curse.

When the European Central Bank president convenes his Governing Council this week, the 24 policy makers will have to judge how the plunge in oil prices will affect inflation expectations in the euro area and what they should do about it. Crude’s biggest drop in three years, after OPEC opted not to reduce a supply glut, puts downward pressure on consumer prices that are already close to stagnating.

German council member Jens Weidmann signaled how oil is now a focal point in the quantitative-easing debate when he said last week that the drop in energy costs is like a mini stimulus package, suggesting no need for the ECB to expand its current measures. The opposing view, previously argued by Draghi and ECB Chief Economist Peter Praet, is that temporary price shocks can deliver lasting harm to an economy as feeble as the euro area’s.

The decision by the Organization of Petroleum Exporting Countries “makes forceful ECB action more likely,” said Holger Sandte, chief European analyst at Nordea Markets in Copenhagen. “Later out in 2015, we might see positive impacts on the economy from the lower energy prices but that won’t stop the doves on the Governing Council pushing for action.”

Getting Ready

Adding to the case for stimulus is a report today that shows that German manufacturing unexpected contracted last month, dragging factories in the euro area to the brink of stagnation.

With official interest rates at the lower bound, investors will watch Draghi’s Dec. 4 post-meeting press conference to see if he’s ready to take further unconventional steps, including large-scale sovereign-debt purchases, to boost the economy.

Action isn’t necessarily imminent. ECB Vice President Vitor Constancio said last week that the best time to judge whether current stimulus is adequate is in the first quarter of next year. Executive Board member Benoit Coeure said policy makers won’t act in haste.

Still, ECB staff have been tasked with preparing measures and Draghi says policy makers are unanimous in their commitment to add stimulus if needed. On Nov. 21 in Frankfurt, he said “we will do what we must to raise inflation and inflation expectations as fast as possible.”

The urgency to do so hasn’t dissipated. Data last week showed inflation slowed to 0.3 percent in November, matching a five-year low. The ECB’s goal is just under 2 percent.

Deflationary Spiral

A key driver of the drop is energy prices, which fell 2.5 percent from a year earlier. Brent crude has plunged more than 30 percent in the past three months and slid to the lowest level since 2009 after OPEC, which accounts for about 40 percent of the world’s oil supply, said it would keep its collective production ceiling unchanged.

While that could bring much-needed cost savings to companies and consumers, the ECB also has to consider whether the effect on headline inflation figures in coming months will change longer-term price perceptions. Draghi’s fear is that the euro area gets sucked into a spiral of declining prices which makes it harder to reduce debt burdens, delays consumer purchases and reduces the incentive for companies to invest.

“Negative energy-price shocks may not only push down inflation over a prolonged period, but may feed into people’s expectations of future inflation,” Praet said in a speech in July. If that causes households to postpone spending, “monetary policy should provide additional accommodation,” he said.

Geopolitical Risk

That’s in line with comments made by Draghi in a policy speech in Amsterdam in April. A “positive supply shock” that disanchors inflation expectations would be a contingency for broad-based asset purchases, he said. While the ECB has since then started buying covered bonds and asset-backed securities, most economists in Bloomberg’s monthly survey in November predicted it will have to expand the program.

Another risk is that plunging oil prices curb government revenues in energy-exporting countries such as sanctions-hit Russia and Iran, exacerbating political instability in regions that the ECB has already warned could detract from the euro area’s revival. Draghi said after last month’s policy meeting that “heightened geopolitical risks” could dampen confidence and investment.

The ECB president acknowledged that there is reason for caution in reacting to energy prices when he said in his Nov. 21 speech that they can be volatile and the ECB could to “some extent” look through them because they raise real disposable incomes. That’s an argument some policy makers are likely to pursue.

Stimulus Effect

“There’s a stimulant effect coming from the energy prices,” Weidmann said in Berlin last week. “It’s like a mini stimulus package.”

Weidmann opposed the ECB’s decision to buy ABS and has said he sees high legal hurdles for purchasing government debt. Executive Board member Sabine Lautenschlaeger echoed that position on Nov. 29 when she said it will take at least three to five months to be able to gauge the effect of current stimulus and “the hurdles for further measures are very high, especially for broad purchase programs.”

Policy makers including Estonia’s Ardo Hansson and Austria’s Ewald Nowotny have indicated that it’s too early to act again and that time must be allowed to assess existing measures, which include long-term loans to banks. Nowotny and Finland’s Erkki Liikanen have said officials must differentiate between core inflation, which was 0.7 percent in November, and price changes caused by external factors such as energy.

Even so, the drop in oil prices will probably accelerate any move toward government-bond purchases, according to Roberto Perli, a partner at Cornerstone Macro LP in Washington.

“While until recently I believed the ECB could announce a QE program in the second quarter of 2015, odds of an earlier announcement are increasing,” he said by e-mail. “The decision by OPEC not to cut production obviously puts further downward pressure on oil prices and as such is disinflationary.”