Low inflation rate in the Euro Area – A complex situation

The inflation rate in the Euro Area was at 0.5% in March. Except during the period with high volatility in oil price, in 2008/2009, the yearly change of the consumption price index has not been so low.
The chart below shows statistics of the inflation rate since its inception. I’ve also shown the core inflation rate which also close to its historical low.
EA-2014-March-InflationOf course there is a fear of deflation but that’s not as simple as that.
Two remarks:
1 – The inflation rate is low, too low compared to the ECB target of 2%. The central bank has forecasted that inflation rate will just be at 1.5% in 2016. Convergence to the 2% target will be longer may be not before 2020. Such a situation can drive price expectations lower and at the end can have an economic cost.
The 2% inflation rate target has to be considered as a neutral inflation rate without too much influence on behaviors. If inflation is lower than 2%, the cost will come with lower nominal wages, no nominal illusion and a low incentive to spend.
It is to avoid such a dynamics that the ECB has to intervene. It has to change expectations so that these latter converge to 2% more rapidly.
To avoid the negative consequences of deflation, the ECB has to change the framework by first changing expectations.
2 – The second issue is to look at the inflation rate momentum. For that, I have calculated the inflation rate for the first quarter, comparing March 2014 to December 2013. I’ve done that for the last four years for headline and core price indices.
That’s shown on the chart below. On the left part, headline index is shown and on the right part it is the core index.
We see that if headline inflation rate has decreased dramatically, this is not the case for core inflation rate. This means that lower inflation rate mainly reflects fluctuations of commodity prices.
EA-2014-march-InflationQ1This has a very complicated consequence for the ECB. On one side, the core index that can be under the influence of the ECB monetary policy does not show dramatic drop. This could lead the ECB to an unchanged behavior. On the other side, doing nothing could lead to lower price expectations and a kind of self-fulfilling behavior leading to deflation.
That’s why the ECB has to intervene. Nevertheless, the question is on the instrument it can use for that. QE is not on the menu for regulatory reason; a new VLTRO is not necessarily on the agenda because the ECB cannot force banks to make new loans to companies, specifically to SME’s. The ABS market is too narrow to be a real instrument for monetary policy. The last instrument to increase liquidity is to end the sterilization operation that has started with SMP operations. But it’s just a one shot of EUR 175bn. It will not increase through time as it can be done with QE operations.
The tight situation in the Euro Area comes from this environment, a sort of lack of capacity to change rapidly the current setting. With a more active ECB, the Euro parity would be lower and this could change the whole picture.
This means that probably, ECB rules have to be changed in order to let the monetary institution be the lender of last resort for the Euro Area.
If nothing is done we can imagine lower expectations and a spillover of deflation risks of the headline index to the core index. In that case, it will be too late as the impact will stay for long.

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