Euro-zone inflation numbers worsens Draghi’s dilemma

Euro-zone inflation ticked up 0.2% in CPI and +0.3% Core CPI according to preliminary data for April.  EUR/USD is somewhat higher. The shift in the dates of Easter did have a positive effect on inflation in April, as the ECB expected.

But is this good enough?  Not at all. These numbers just worsen the situation for the ECB and Mario Draghi. He is stuck between a rock and a hard place, especially in light of the exchange rate.

Not too hot, not too cold

The rise in  prices still leaves inflation at the low level of 0.7%, very far from the “2% or a bit below” ECB target. Also core inflation is still at low ground of 1%, also too far.  These low levels  accompany us for a long time already.

On the other hand, the level of inflation  is above the “danger zone” of  below 0.5% where the ECB will be forced to act. Deflation is a danger, but is it really around the corner? Not exactly. It will be hard to convince the German Bundesbank to  set a negative deposit rate or even QE without the urge to do so.

Without imminent action in sight, the value of the  euro rises. Apart from EUR/USD trading on high ground, it is important to remember that with  the recent depreciation of the Chinese yuan, EUR/CNY is at  high levels as well. The high exchange rate makes European exports less attractive and lower import prices also push inflation lower.

Diminishing verbal intervention

The best thing for Draghi would be to have a lower exchange rate for the euro while keeping his powder dry.

Draghi tried various ways of verbal intervention, including an explicit correlation between monetary policy and the value of the euro.

Each verbal intervention has less impact than the previous ones. The diminishing effect is  eroding the credibility of the ECB and has little impact on the markets.

After Draghi tied policy to the exchange rate, will he indeed act just because of the exchange rate? Will his German colleagues on the Governing Council stand shoulder to shoulder with him on this?

Draghi’s  next policy move is definitely a complicated task.

What do you think?

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