Lower lowflation in the eurozone

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Inflation rates have fallen significantly in the eurozone this year and led the European Central Bank (ECB) to announce a series of measures to head off deflationary threats. For the moment however there is little sign of an end to the disinflationary trend.

Headline inflation rates in the eurozone continue to decline extending a fall that began last November with inflation remaining stubbornly below 1% since. In June, Eurostat, the commission’s statistics bureau, announced a headline inflation rate for the eurozone of 0.5%. This was followed, on July 31, by the news of a further drop in the rate of inflation, year-on-year, to 0.4%, the lowest level in five years, with the core rate (excluding the more volatile components) at 0.9%. Finally, on October 16 Eurostat confirmed that eurozone consumer price inflation made a new five-year low of 0.3% in September.

Apart from raising doubts about the credibility of the ECB’s target for eurozone inflation (0.3% being a long way from the ECB’s inflation target of close to but below 2%) this “lowflation” means the  eurozone is vulnerable –  there is currently barely any inflationary cushion to shield the eurozone economy. So the deflationary impact of an extraneous economic shock could conceivably tip the eurozone economy into a more severe deflationary spiral.

Disinflation is currently a worldwide phenomenon. In the UK and United States inflation is currently running below the 2% level targeted by the Bank of England and the US Federal Reserve. Inflation in Greece, Italy and Spain is now negative. In China inflation is running at a level below 2% – relative to the 4% target set by the central government.

The latest blast of disinflation is a consequence of the fall in oil prices from around USD 115 in late June to below USD 80 today (click here for an interactive graph of US crude oil prices). While falling oil prices are a boon to oil importers the bad news is that they appear to be the result of a slowdown in growth around the world. So while the the fall in energy prices should give a boost to consumer purchasing power there’s a risk it reinforces perceptions that we are in a world of falling prices where consumers can buy cheaper next month.

In June, Mario Draghi, President of the ECB, announced a series of measures aimed at countering falling inflation rates but also made a remarkable downgrade in the central bank’s inflation forecast. He revised down the inflation forecast in September before repeating the exercise on December 4 2014 to integrate the impact of lower oil prices (though Mr Draghi stressed that the stressed that the latest projections do not include the latest fall in oil prices). The ECB now predicts prices will rise by 0.5% in 2014, 0.7% in 2015 and 1.3% in 2016 (click here for a comprehensive overview of the ECB’s current inflation forecasts). Inflation rates this low aggravate the task of reducing debt burdens and improving competitiveness across the eurozone. Debt deflation would set in motion a brutal dynamic – the fall in the price level raising the real value of debt.

Figure 1: The downward trend in eurozone inflation in recent years is clearly illustrated in the drop of eurozone HICP

Consumer price inflation in the euro area is measured by the Harmonised Index of Consumer Prices (HICP). The HICP is compiled by Eurostat (click here to see an explanation of HICP on the Eurostat website) and the national statistical institutes in accordance with harmonised statistical methods. The ECB’s declared aim is to maintain annual inflation rates as measured by the HICP below, but close to, 2% over the medium term.

The graph below is interactive – move your mouse over the timeline section below the graph to change the time period shown on the graph. Thanks to FRED (Federal Reserve of Economic Data) at Saint Louis in Missouri for this graph.

A period of deflation would be tolerable (even a pleasant thing) if it resulted from greater productivity and raising consumers’ real incomes. Unfortunately this does not appear to be the case today. n light of the current situation, it is worth clarifying the different types of situation that can occur when prices fall in an economy, so as to differentiate between the extreme and more benign outcomes:

Chronic or malign deflation is the bogeyman that keeps central bankers awake at night. A deflationary ’death spiral‘, is characterised by a fall in the general price level and aggregate demand. This is the situation that the US found itself in between 1929 and 1933. During the Great Depression, consumer prices fell by a quarter, real gross domestic product dropped 30% and the unemployment rate rose to about 25%.

Benign deflation is different. In Japan it has been harmless (some would argue even beneficial – Japan’s relatively slow growth in recent years being the result of demography not deflation). Prices remain fairly static and fall occasionally in a healthy economy, but modest wage increases sustain consumer spending and economic growth.

Price adjustment constitutes a third scenario of falling prices. Under this scenario prices readjust downward for a short period. Crucially, the period of falling prices neither becomes ingrained nor leads consumers to reckon with consistently falling prices.

Lowflation is a new term recently[1] coined by Christine Lagarde, managing director of the International Monetary Fund (IMF). Reading between the lines, it would appear that ‘lowflation’ is a crafty invention designed to assist the IMF in implicitly making the case for raising inflation targets above 2%, which is the established target in most developed countries. Experience has taught the IMF that this is a highly sensitive subject that needs to be handled with great care. In 2010, Olivier Blanchard, the IMF’s chief economist, broached the idea that central banks should target an inflation rate of 4% in order to ensure that they have scope to cut interest rates during more difficult times. This recommendation was partly based on analysis by the IMF of the Japanese experience, where the policy rate reached zero in the mid-1990s which was followed by a lost decade. However, Blanchard did not get much chance to explain his rational – the idea that an inflation rate of 4% could constitute a policy target for central banks went down like a lead balloon with more orthodox policymakers. Their thinking having been based on the idea that low or zero inflation was the appropriate long-run goal for monetary policy.

Now that continental Europe finds itself in an uncomfortably exposed lowflationary environment it would appear that policymakers may be better placed to recognise the potential benefits of moderate inflation. In particular, the combination of a steady rate of inflation with low interest rates would create an environment of negative real interest rates and, over time, help considerably in reducing debt burdens.

“Are we finished?” asked Mr Draghi, rhetorically, during his news conference on 5 June. “The answer is no.” If need be, we aren’t finished here.”  The point being that if disinflation continues the ECB bank may have to resort to “full-blooded” (i.e. including purchases of sovereign debt) quantitative easing as practiced since the financial crisis by the Federal Reserve and the Bank of England.

Back in June the ECB signalled that it would likely to wait until the end of the year to judge the impact of its measures unveiled in June. However economic data published over the summer suggesting the eurozone’s economy has weakened and the price pressures had further eased forced the council to act again. On September Mario Draghi startled markets by announcing a cut in the ECB’s main refinancing rate from 0.15% to 0.05% along with measures to revive lending by pledging to buy hundreds of billions of euros of private sector asset-backed securities and covered bonds (click here for a full analysis of the measures announced by Mario Draghi on September 4, 2014). Mr Draghi paved the way for this new package of measures at the annual meeting of central bankers at Jackson Hole when he recognised that markets has started to doubt the ECB’s ability to get the inflation rate back to its target of just below 2%.

Having made on September 4, what Mr Draghi himself called “the final rate cut” and the announced the purchasing programmes for ABS and covered bonds, the ECB has now reached the point at which outright purchases of government bonds is the only policy option left to the ECB. Data released since the start of September suggest that there has been absolutely no let-up in the eurozone’s disinflationary pressures and that the ECB’s policy measures are not, so far, having the desired effect (click here for a comment on the results of the ECB’s first round of loans to banks in the eurozone).

[1] Christine Lagarde, in a speech on 2 April 2014 ahead of the IMF’s spring meetings. See also http://blog-imfdirect.imf.org/2014/03/04/euro-area-deflation-versus-lowflation/

Written on June 2nd 2014, updated on July 31 and September 22 2014.
Andrew C. Craig

Head of Financial Market Analysis & Publications

2 thoughts on “Lower lowflation in the eurozone”

  1. Hi Joe,

    No, we do not think that the ECB will undertake any QE this year. In our view they want to have enough time to assess the effects of the raft of measures they announced on June 6. We’d expect they need until well into the second half of the year to make such and assessment and draw their conclusions. For this reason we see QE from the ECB as unlikely this year.

    Best regards

    Andy Craig
    Editor Investors corner blog
    BNP Paribas Investment Partners

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