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Danger zone

8 January 2014 By Pierre Briançon

Mario Draghi is playing with fire. The European Central Bank accepts that the euro zone has entered a long period of low inflation – but its president sees no need to act on it. If Draghi keeps hesitating, he risks the institution’s credibility, squandering the gains of his 2012 promise to do “everything it takes” to preserve the euro.

According to the ECB party line, the euro zone’s inflation rate (0.8 percent according to the latest numbers), is low enough to be disruptive if it persists. But there is no current danger of deflation, since consumers and businesses expect a 2 percent rate over the five-year term.

That complacency is misplaced, because it is based on the euro zone average. Some euro member countries are already close to the deflation danger zone. In any case, the ECB is in breach of its longstanding and self-imposed mandate to keep inflation “below but close” to 2 percent. According to its own forecast, a weak recovery will keep the inflation rate at 1.1 percent this year and 1.3 percent in 2015.

Deflation is the expectation of a permanent decrease of the price index, so Draghi may seem to be right. Inflation is low but still positive. Nominal hourly labour costs were up 1 percent last year, leaving wages roughly stable in real terms. For now, the monetary union isn’t in danger of replicating Japan’s years of small price and wage declines.

The stability is partly due, by the way, to the labour market “rigidities” pilloried by the Frankfurt-to-Brussels consensus on the need for so-called “structural” reforms. Had nominal wages been as flexible as the austerity brigade advocates, deflation would already have struck.

Mario Draghi may take comfort in the current inflation expectations, but he must know that the science of measuring them is uncertain at best. Of more immediate concern is the possibility that deflation could occur in just a few member countries.

According to the latest available numbers, prices are roughly stable year-on-year in Spain, Portugal and Ireland and barely moving in Italy and France. They are falling sharply in Greece (minus 2.9 percent year-on-year), more slowly in Cyprus (minus 0.8 percent). Near-zero inflation coupled with negative growth rates – as seen last year in Greece, Cyprus, Spain, Italy, Portugal, Slovenia and the Netherlands – means that real interest rates remain positive, increasing the burden of debts.

Should any of these countries be caught in the deflation spiral, the ECB will find it is too late to react. For while central bankers know how to fight inflation – with higher interest rates – they don’t know how to fight deflation once it has taken hold, especially when policy interest rates are almost zero.

Granted, the ECB has a specific problem: the segmentation of the euro zone’s money and credit markets. In theory, it could try to aim monetary policies at the weakest economies of the euro zone. In practice, the policies face strong German opposition.

The Bundesbank never misses an opportunity to trumpet the risks of higher inflation and low interest rates, while screaming newspaper headlines accuse Draghi-the-Italian of leading German savers to ruin. Accommodation for the South meets reprobation in the North.

The ECB president told German magazine Der Spiegel a few days ago that he saw “no need for immediate action” on the deflation front. This week he is likely to insist yet again on the central bank’s effort to “repair the monetary transmission mechanism” – with low interest rates and the launch of the banking union. 

But his is a dangerous game. The damage from waiting could be irreparable. How long can he afford to delay policies specifically designed to produce asymmetrical effects – such as a targeted liquidity boost that would ensure that ECB money flows down to the businesses that need it most? At some point he will have to deal with the German challenge head on. Better now than later.


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