A nice paper from the St Louis Fed is making the point that, unlike the Federal Reserve’s second Quantitative Easing (QE2), Mario Draghi’s  new measures, which includes the 550b Targeted Long Term Financing Operations (TLTR0), announced on May 8 and implemented on June 5, are so far failing in raising market expectations of future inflation.

This is a huge flop: the expansionary effects of monetary policy cannot rely on further reductions of policy  nominal interest rates, already  negative, and therefore they hinge upon the ECB’s ability to raise inflationary expectations, thus reducing long term  real intereat rates. This is simply not happening.

This is true for the largest European economies, but the news is particularly bad for Italy. Here, despite Draghi’s announcements and measures, expected inflation has entered negative territory in May. The picture above shows the Treasury Break Even Interest Rate, the difference between the one-year government bond nominal yield and the corresponding yield on a inflation-indexed government bond. The premium represent the excess return markets demand for covering expected inflation (actually this spread is the expected rate of inflation over one year, if investors are risk neural). As the graph shows, this measure of inflationary expectations has turned negative in May.

Thus, long before ISTAT, the Italian Statistical Agency, certified for Italy a new recession with two consecutive quarters of negative GDP growth, markets were already pricing negative inflation rates into assets yields.

The risks for a recession-deflation spiral, with dangerous consequences for unemployment and debt sustainability are growing.

PS; (in Italian) Ministro Padoan, se ci sei batti un colpo