Euro area: deflation is the wrong debate
For a fact, measures of headline consumer price inflation have decelerated sharply over the recent past. At 0.8-1%; inflation hovers around levels that are clearly below the ECB’s flagship 2% medium-term objective.
By Natacha Valla
Post
Many voices concur in viewing current inflation dynamics as a cause of major concern. Deflation, so they say, would be around the corner, prompting more decisive preemptive action on the part of the ECB.
But deflation refers to a self-reinforcing fall in prices that is broad-based across items and across countries. That is not what we see right now. In fact, global inflation has been driven down by a sharp deceleration in volatile price components, in particular energy prices.
True, wages have been unanchored by structural reforms, and core inflation (the measure of inflation that excludes volatile components such as energy or food prices) has been oscillating around 1% for a few years now.
This is low, but not alarming, in particular in the context of the massive internal rebalancing efforts made by southern Euro area countries. Core inflation could have fallen much further given that nominal wages have been cut by orders of magnitude of 20% in some countries!
Furthermore, it does not look as though consumers are massively postponing expenditure plans because they expect prices to go down. Medium-term inflation expectations (measured for example by the five-year interest rate swap market) are low, but they do not show signs of becoming unanchored either.
In fact, one might even take the opposite, “anti-deflation” view in the current context.
Disinflation forces that have cumulated in recent years might indeed stabilize. First, the economic recovery gradually takes hold in core euro area countries - Germany proceeds ahead, France muddles through. Second, private sector consumption might stabilize soon in the likes of Spain because the worst speed of real exchange rate adjustment is likely to be behind us. Third, commodity markets are not expected to deliver unexpected slumps in oil and commodity prices over the quarters to come – if at all, geopolitical risks might even play in the other direction.
Beyond such short-term forces, two more fundamental trends might impose (welcome) upward pressures on the formation of prices. The first factor is private sector investment. The euro area as a whole – Germany included – has suffered from a massive and historically prolonged destruction of its capital stock because private sector investment remained dead for more than two years. Capacity constraints might therefore bite sooner rather than later when conjunctural improvements really take ground. Of course, this might in turn trigger an “investment rush” where firms race up to rebuild productive capacities so as to release capacity constraints. Either way, investment developments should counter any deflationary force that could be at play.
The second factor pertains to world trade. Over the decade prior to the crisis, the western world has “imported” big time disinflation by buying cheap goods and services from the emerging world. Those golden times might be over.
But should this deflation debate really matter for the ECB? Paradoxically, not really, for its urgent policy choices have to be taken independently from price dynamics. A paradox for an institution that insists in keeping the single objective of price stability! Either way (inflation or deflation), the ECB should stand ready to act if sovereign markets come under pressure again. Either way, the banking system needs to be rebooted to support credit and growth. And either way, the ECB should make contingent plans in case its OMT program needs to be activated. Those hurdles look high. Much higher than price stability.
But deflation refers to a self-reinforcing fall in prices that is broad-based across items and across countries. That is not what we see right now. In fact, global inflation has been driven down by a sharp deceleration in volatile price components, in particular energy prices.
True, wages have been unanchored by structural reforms, and core inflation (the measure of inflation that excludes volatile components such as energy or food prices) has been oscillating around 1% for a few years now.
This is low, but not alarming, in particular in the context of the massive internal rebalancing efforts made by southern Euro area countries. Core inflation could have fallen much further given that nominal wages have been cut by orders of magnitude of 20% in some countries!
Furthermore, it does not look as though consumers are massively postponing expenditure plans because they expect prices to go down. Medium-term inflation expectations (measured for example by the five-year interest rate swap market) are low, but they do not show signs of becoming unanchored either.
In fact, one might even take the opposite, “anti-deflation” view in the current context.
Disinflation forces that have cumulated in recent years might indeed stabilize. First, the economic recovery gradually takes hold in core euro area countries - Germany proceeds ahead, France muddles through. Second, private sector consumption might stabilize soon in the likes of Spain because the worst speed of real exchange rate adjustment is likely to be behind us. Third, commodity markets are not expected to deliver unexpected slumps in oil and commodity prices over the quarters to come – if at all, geopolitical risks might even play in the other direction.
Beyond such short-term forces, two more fundamental trends might impose (welcome) upward pressures on the formation of prices. The first factor is private sector investment. The euro area as a whole – Germany included – has suffered from a massive and historically prolonged destruction of its capital stock because private sector investment remained dead for more than two years. Capacity constraints might therefore bite sooner rather than later when conjunctural improvements really take ground. Of course, this might in turn trigger an “investment rush” where firms race up to rebuild productive capacities so as to release capacity constraints. Either way, investment developments should counter any deflationary force that could be at play.
The second factor pertains to world trade. Over the decade prior to the crisis, the western world has “imported” big time disinflation by buying cheap goods and services from the emerging world. Those golden times might be over.
But should this deflation debate really matter for the ECB? Paradoxically, not really, for its urgent policy choices have to be taken independently from price dynamics. A paradox for an institution that insists in keeping the single objective of price stability! Either way (inflation or deflation), the ECB should stand ready to act if sovereign markets come under pressure again. Either way, the banking system needs to be rebooted to support credit and growth. And either way, the ECB should make contingent plans in case its OMT program needs to be activated. Those hurdles look high. Much higher than price stability.
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