With the latest inflation data of the euro area, fighting the risk of deflation is a new policy challenge for the ECB. While the interest rate cut has been a reasonable policy choice, policy options are unclear if the price decline becomes persistent.
On October 31st, Eurostat – the statistical office of the European Union – announced its latest position on euro area inflation. The flash estimate of annual inflation in the Harmonized Index of Consumer Prices (HICP) suggested a decrease from 1.1% in September to 0.7% in October – the slowest pace in four years.
This news came as another shock to the already fragile state of the euro area economy. Its problems started with the onset of the sovereign debt crisis nearly four years ago. What followed were fiscal austerity and structural adjustment programs for a number of countries. They caused the longest-ever recession since the euro area was established in 1999. The recession only ended in the second quarter this year after six quarters of falling output.
With the unemployment rate standing at a record level of 12.2%, the estimate of a falling inflation rate only added to the markets’ negative perception of economic prospects. This estimate is much below the ECB’s aim of maintaining inflation rates below, but close to, 2% over the medium term. The estimated decline was particularly strongly affected by lower food price inflation, a larger fall in energy prices and a moderate fall in services price inflation (Table 1).
Table 1. Euro area annual inflation and its components: September – October 2013 (In %; p – provisional, e – estimate, HICP – Harmonized Index of Consumer Prices)
|
September 2013 |
October 2013 |
|
| All-Items HICP |
1.1p |
0.7e |
| Food, alcohol & tobacco |
2.6p |
1.9e |
| Energy |
-0.9p |
-1.7e |
| Non-energy industrial goods |
0.4p |
0.4e |
| Services |
1.4p |
1.2e |
Source: Eurostat
The reaction of the ECB followed swiftly. On November 7th, the Governing Council of the ECB decided to lower the interest rate on the main refinancing operations of the Eurosystem by 25 basis points to a record low of 0.25%. In explaining the ECB’s stance, President Mario Draghi clearly stated that the underlying price pressures in the euro area were expected to remain subdued over the medium term, followed by a gradual upward movement toward the ECB’s mandate later on.
Interestingly, Mr. Draghi’s remarks at the press conference after the rate decision did not contain a word that many observers have used when discussing the expected price dynamics: deflation. It was only following a direct question by the press that he clarified that the ECB did not see deflation happening in the euro area. Instead, he interpreted the expected price dynamics as a broadly based and protracted period of low inflation.
This news makes a strong case for the ECB to carefully examine theoretical propositions and Japanese experience in fighting deflation. The major risk of excessively low inflation rates, as is the case currently, is that such price declines risk becoming persistent. It is a common position that price declines increase the burden of repaying loans fixed in nominal terms.
Moreover, once people start expecting price declines, they postpone spending, weakening economy further. This has already happened in Japan, which is only now gradually escaping fifteen years of deflation. An insightful paper about its experience found that deflation, which occurs as a result of a decline in aggregate demand, is likely to be harmful, both because it interferes with the efficient functioning of financial markets and because it makes monetary policy hard to conduct.
Going forward, the good news is that the ECB’s preemptive monetary easing is expected to strengthen already well-anchored inflationary expectations around the level defined by its mandate. It remains to be seen, however, whether the expected price decline will become persistent and what policy options will be chosen once the benchmark interest rate reaches the zero bound. And it is dangerously close to this level.
