Eurozone Deflation: What to Be Afraid of?

Written by | Monday, March 3rd, 2014
Shigemura Hiroyuki

Economic logic sometimes seems to go against the laws of common sense. As a result, it seems completely insane to an average representative agent in the economy to hear that falling prices are worse than increasing prices. Such is life now in the eurozone. The traditional role of a central bank has always been to fight inflation – in everyday life experienced as the rise in the general level of prices. Yet, the European Central Bank (ECB) is now busy to tackle deflation – falling prices – which is actually far worse than inflation – at least from an economic point of view.
The ECB’s official inflation target is a whisker below 2 percent whereas the actual inflation rate was somewhere about 0.7 percent in January, far below its desired number. Officially, this trend was labelled “disinflation” (a falling rate of inflation) probably because calling it “deflation” could be potentially very dangerous to Europe’s nascent recovery. Moreover, the fact is that it is rather hard to spot whether one is in deflation, and when one is really already in, it is usually too late. “That is what Japan found,” said Gilles Moëc, chief European economist at Deutsche Bank in London.
In the 1990s, Japan experienced a sudden economic boom that was followed by a wave of deflation caused by plummeting land prices, a process that had tremendous consequences for individuals’ savings, firms, and banks. When prices keep on going down, which is what happens during deflation, economic agents expect that this trend will continue. This means that when we consider the current decline of prices a messenger of a further decline, we postpone our consumption and other economic decisions to future in a belief that we will pay even less.
Companies do the same. Anticipating further decline in prices, firms put off their investment decisions, thus undermining growth. When deflation takes hold, it further lowers corporate income and the values of assets, such as real estate, as well as hinders wage growth. Moreover, in economies battered by debt overhang – just like the eurozone of today – deflation can give a rise to a downward spiral in which borrowers cannot repay their loans on devalued assets. As such, deflation is very stressful for banks as they hold loans that are increasingly difficult to be repaid as money gets more precious. In contrast, inflation does the opposite. A rise in the general level of prices is what borrowers like as the value of their loans is eroded by increasing prices, making it easier to repay debts.
The ECB is keenly aware of the dangers of inflation, yet its options to handle it are rather limited. The bank already decreased its main interest rate to historic low of 0.25 percent in November last year. Moreover, as nominal interest rates cannot fall below zero, the room for action lies somewhere in the interval from zero to 0.25. Manipulating interest rates is ECB’s conventional tool for influencing prices but deflation may make it exceptionally difficult to achieve this as monetary policy is often insufficient to boost demand under deflation. Nonetheless, monetary policy de facto remains the ECB’s only tool to do anything about inflation rate approaching zero.
Olivier Blanchard, the chief economist of the International Monetary Fund, said that there was nothing really magical about the zero number turning inflation into deflation. He insisted though that Frankfurt’s monetary policy be highly flexible, dynamic, and accommodative in order to minimize potential risks deflation can bring. Mr Moëc of Deutsche Bank also added that the ECB could also opt for the so-called technical measures to provide the market with more cash by as much as 160 billion euro. Eventually, the bank could also signal a small rate cut or even decrease its already historic low of 0.25 to 0.15 percent. He even proposed that the ECB could also contemplate negative interest rates, which, although used before elsewhere, yielded ambiguous consequences. ECB President Mario Draghi replied to worrying economists that his institution would use all options at its disposal to fight deflation may it arise, yet he said there was nothing to be afraid of at this point. Many economists would likely disagree.

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