Focus Of The Day
"One of our main foreign exchange forecasts – that EUR/$ will fall a lot further – hinges critically on the view that inflation in the Euro zone will be slow to rise. Our thinking is that structural reforms on the Euro periphery are deflationary, since they aim to restore competitiveness by cutting wage and price levels. As a result, periphery low inflation (or even deflation) is partly structural, i.e. slower to respond to expansionary monetary policy than otherwise.
We take a closer look at inflation in the Euro zone, in particular whether there is a structural element to dis-inflation on the periphery. We exploit the cross section of countries in the Euro zone to examine whether the Phillips curve – the link between inflation and slack – has shifted down on the periphery due to structural reforms, in contrast to core countries like Germany, which are not under pressure to reform product and labor markets.
We find some evidence that periphery Phillips curves have shifted down, in particular in Greece, Portugal and Spain, while they look relatively stable in core countries. The periphery shift down has spilled over to the Euro zone as a whole, with recent inflation readings lower than predicted by the historical Phillips curve relationship. Obviously, these results are subject to caveats, notably that slack on the periphery is difficult to measure, especially in the presence of structural reforms. That said, we see our results as consistent with our view that low inflation in the Euro zone is partly structural, which supports our view that ECB QE will last at least through September next year, which in turn supports our EUR/$ downside view."
Robin Brooks, George Cole, Michael Cahill - Goldman Sachs (NYSE:GS)
**GS sees EUR/USD trading at 1.02, 1.00, and 0.95 in 3, 6, and 12-month respectively.