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The ECB is freaking out and ran out of ideas to stimulate the economic activity in the Eurozone as the inflation rate is reaching alarmingly low levels. ECB President Draghi’s main fear is that because the inflation is expected to be low, it will remain low. It doesn’t happen very often that a president of a central bank is panicking because of a self-fulfilling prophecy, but Draghi surely seems to be a bit lost.

Whereas everybody would have been crying wolf a few years ago if anyone would have dared to launch a buyback program of sovereign bonds, the idea is gaining more and more ground. Before the Global Financial Crisis in 2008 the ECB’s only mission statement was to keep the inflation at a steady rate of close to, but below 2% which was thought to be the ‘perfect’ inflation rate on a macro-economic level as it would ensure some sort of sustainable growth.

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As it started to look like the annual inflation rate in the Eurozone was very far off the 2% mark, Draghi promised to dust off his 1000 billion euro bazooka, but this didn’t seem to help to create a self-fulfilling prophecy on his own. It looks like that bazooka will indeed have to be loaded now and the big question is what Draghi will do with his available funds. It’s starting to look inevitable to effectively start buying sovereign bonds and that could make the ECB one of the member country’s main financiers. Of course this also increases the moral hazard risk as weaker countries might consider this to be a first line of credit instead of seeing the ECB as a ‘lender of last resort’ which it intended to be.

This also brings up the topic of Eurobonds again, and we will discuss this matter in another column. This could solve a part of the problem, but then again you risk to fuel the moral hazard problem as the fate of several countries would be intertwined and there would be no incentive at all to even try to be best of the class if you can move your sovereign risk onto a ‘pool’ of countries.

The issue is that because the inflation expectations in the Eurozone are this low, there’s a real spillover-effect onto other countries and the financial stability in those other countries and currency zones. As the yield on bonds (both corporate bonds and government bonds) has been decreasing as well, a lot of Euro-investors are running towards alternatives and obviously the main possible alternative is buying US Treasuries. This results in quite an interesting phenomenon as even though the US inflation rate is on the rise, the yield on the treasuries (see the next image for an impression of the yield on the 10 year US government bond) stays low which would result in an effective loss of purchasing power for domestic investors in treasuries.

Source: Yahoo Finance

This is great for the US government as it’s able to re-finance its debt at a cheaper than expected interest rate, but if you analyze the situation from a more objective point of view, you immediately see this is a very weird situation. You’d expect the US Treasuries to trade at a yield which is at least keeping up with the inflation, as one would expect the EUR/USD exchange rate to fluctuate based on the expected inflation rate in both currency zones. The issue is that running into the USD is also a part of the flight to safety, and several forex analysts are now even expecting the EUR to lose more ground to the USD and are aiming for a ‘new normal’ of 1.15. This is obviously an incentive to buy even more US treasuries (as on top of the yield, investors would benefit from an appreciating USD).

Needless to say that there’s a capital drain going on in the Eurozone, and this might make an economic recovery more difficult. And that’s why Draghi is panicking and desperately wants to increase the inflation rate. The (sovereign) debt would be inflated away and any economic recovery would keep more capital within the Eurozone.