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Deflationary dangers

5 February 2014 By Hugo Dixon

The European Central Bank needs to start taking the risks of deflation more seriously. This danger should be top of its agenda when its governing council convenes for its monthly meeting this week.

The ECB’s line is that it does not see deflation on the horizon. True, the inflation rate has been below the target of close to but below 2 percent for over a year. The flash estimate for January was a mere 0.7 percent. But this still amounts to rising prices – not deflation’s actually falling prices.

True, too, that the ECB itself expects inflation to be below target for at least the next two years. But it doesn’t think the euro zone is close to repeating the experience of Japan which has suffered 20 years of flat prices.

Last month, Mario Draghi, the ECB’s president, gave four reasons why. First, the ECB had taken early decisive action. Second, the euro zone’s banking and corporate balance sheets are not in as bad shape as Japan’s were in the 1990s. Third, the ECB is moving ahead with a rigorous stress test to clean up bank balance sheets. Finally, inflationary expectations in the medium term – essentially the next five years – remain “firmly anchored” at the target level.

Each point needs qualification. First, although the ECB was moderately quick to cut interest rates, it has so far resisted engaging in quantitative easing – the most effective tool for combating deflation.

Second, even if the euro zone’s corporate balance sheets are in better shape than Japan’s were, its governments’ balance sheets are not. High debts are harder to manage in a low-inflation environment, let alone a deflationary one.

Third, while the euro zone is finally trying to clean up its banks’ balance sheets, it has waited far too long to do so. What’s more, in the short run, banks have responded to the need to improve their capital ratios by further deleveraging their balance sheets – which has provided another drag on the economy.

Finally, it’s not really clear that medium-term inflationary expectations are “firmly anchored” at the target level. The ECB’s evidence for this is derived from bond prices and surveys of economists. But all that shows is that inflationary expectations are at the target level, not that they are anchored there – let alone anchored firmly.

The risk is that inflationary expectations will lose their anchor as actual inflation undershoots its target month after month. If so, the euro zone could be tipped into a self-fulfilling deflationary spiral – where low inflation discourages spending and borrowing, which further depresses economic activity and inflation.

The worry is that it would then be hard to re-anchor expectations – not least because the ECB would have lost credibility. This is a strong reason for not leaving action to combat low inflation until it’s too late – especially since unemployment is so high and the risks of stoking an inflationary boom are pretty low.

Not that the ECB is complacent. For example, Draghi said last month: “We do not see deflation right now, but, if we were to have low inflation for a very protracted period of time, it is quite clear that we should be extremely aware of the potential downside risks.” He also said: “We will act when we have reason to think that our medium-term assessment for inflation is changing for the worse…. and we stand ready to use all the needed instruments that are allowed by the Treaty.”

Since Draghi made those remarks, two events have increased the risks of deflation. First, inflation has dropped further. That probably took Draghi by surprise given that he described December’s 0.8 percent rate as a “one-off” event.

Second, the trouble in emerging markets has made life tougher for the euro zone. This is partly because a slowdown in markets such as Turkey, India and China will make it harder for the euro zone to grow through exports. It is also because there may be some psychological contagion to weaker euro zone countries: Greek bond yields have risen by about 1 percentage point in the past month.

But the main negative impact could come through a stronger exchange rate. At the moment, the euro has not been the currency of choice as investors fleeing emerging markets have plumped for the safe haven of the dollar. But the euro has still risen against many other currencies. Think of the challenge that the Greek and Cypriot tourist industries could face against a super-competitive Turkey.

A stronger euro wouldn’t just be bad for exports and growth. It would reduce imported inflation.

The obvious way for the ECB to counter deflationary risks is to buy large quantities of government bonds. Not only would this help boost domestic demand; it would push down the euro, help exports and increase imported inflation.

There’s reluctance in the ECB to embark on such a policy, mainly because of the horror in Germany towards anything that smacks of bailing out governments. But if “quantitative easing” was pursued in order to advance the ECB’s objective of hitting its inflation target, the central bank would be acting within its mandate.

The ECB could underline the fact that it was not bailing out weak states by buying bonds issued by all euro zone governments according to the size of their shareholdings in the central bank. It would then buy more German bonds than those of any other country, blunting criticism in Berlin.

Nobody is expecting the ECB to take such a radical step at this week’s meeting. But it should remember the perils of acting too late.


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