Patrick Artus of Natixis is out with a flash note regarding complications for the European Central Bank (ECB) as the central bank looks ahead to a looming confidence crisis.
What are the consequences of the ECB's loss of credibility?
If we measure a central bank's credibility on the basis of long-term inflation expectations, we see that the ECB's credibility has been declining since the start of 2021, while the Federal Reserve's credibility has remained stable.
If the ECB's credibility declines while that of the Federal Reserve remains stable, we would expect:
- A depreciation of the euro/dollar exchange rate combined with capital outflows from the eurozone;
- Higher inflation in the eurozone than in the United States.
If we measure a central bank's credibility by the level of long-term expected inflation, and if we take 5-year inflation swaps inm 5 years or in 10 years as an indicator of long-term expected inflation, we see that since the beginning of 2021 the ECB's credilibity has fallen sharply... (and) the Federal Reserve's credibility has remained stable.
If a central bank loses some of its credibility, we would expect: a depreciation of the exchange rate of its currency combined with capital outflows... (and) higher inflation, since the long-term expected inflation is higher.
This depreciation of the euro against the dollar is indeed the result of the eurozone begin less attractive than the United States for international capital.
The pace of disinflation is significantly higher in the United States than in the eurozone, part of which can be attributed to the gap between trends in long-term expected inflation.
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