EU inflation and deflation

The Eurozone inflation rate is 0.4% (ECB database)  (Sept 2014)

Eurozone HCIP inflation rate

eurozone inflation

HCIP (Harmonized consumer index prices) Source:| (ECB Inflation graphs, sometimes a few months outdated)

Food inflation

food inflation

Food inflation is currently negative. Food inflation tends to be one of the most volatile components. This negative food inflation is one factor reducing the headline rate.

Reasons for low inflation in the Eurozone

1. Temporary factors – lower food / energy prices. Core inflation is currently higher than the headline rate. Excluding energy, food, alcohol and tobacco, the inflation rate is 0.9%. However, even this core inflation is still well below the government’s target. Also, the headline rate of 0.4% is important for anchoring low inflation expectations. M. Draghi wrote about his concern of an inflation rate permanently below 1%-  which will anchor low inflation expectations (Der Spiegel interview)

2. Sluggish growth

Economic growth in the European Union has been very weak since the start of the great recession in 2007. Weak economic growth has put downward pressure on wages and prices.

Eu-growth

EU Real GDP Source: St Louis Fred

3. Unemployment

eurozone-unemployment

Eurozone unemployment has been above 10% since the middle of 2009. Persistently high unemployment rates create downward pressure on wages. With large pools of unemployed labour – there is downward pressure on wages, which is big factor in keeping overall inflation low.

4. Inflation expectations

Despite the on-going recession, the ECB and European officials have placed great stress on keeping inflation low. This is one factor that has helped anchor low inflation expectations throughout the Eurozone.

5. Monetary policy

The ECB has recently cut the interest rate, but in 2011 – concerned at a blip in inflation – they increased interest rates. The ECB have always erred on the side of caution with regard to inflation, but the effect has been a relatively tight monetary policy which has kept nominal GDP growth low. The other big difference between Europe and other areas such as the UK and US is that whilst the UK has US have embraced quantitative easing to increase the money supply, the ECB has not sought to create more money to deal with deflationary pressure. There is great resistance to this idea, especially in Germany. This is a reasons Eurozone inflation is lower than elsewhere.

6. Internal devaluation

In the Eurozone, many countries such as Portugal, Greece, Spain became uncompetitive in the Single currency. This led to large current account deficit. But, in the Eurozone, these countries can’t allow their currency to devalue. Instead they are pursuing internal devaluation – trying to restore competitiveness through lower wages, and cutting prices. However, this process inevitably causes lower inflation. Both Greece and Portugal have outright deflation as a consequence of this policy.

6. Austerity measures

The Eurozone crisis led to many countries implement austerity to cut budget deficits. In a recession, austerity measures have slowed down economic growth contributing to lower nflation.

7. Reluctance to reflate the economy

The Eurozone has a big trade imbalance – with Germany having a large current account surplus – indicating domestic demand is relatively low compared to export demand. Germany has room to boost domestic spending which would help the south of Europe restore competitiveness and increase exports. But, Germany is not keen on risking any inflation, so they have held back on domestic spending, keeping overall Eurozone GDP growth low.

Problems of low inflation rate

In one sense a low inflation is good news for consumers who are enjoying low food prices e.t.c. However, the problem is that this low inflation is entrenched and so we are likely to see this leading to wage freezes. Low inflation does not help consumers if wages are not growing (something UK is experiencing at the moment)

The bigger problems of low inflation is that it is increasing EU wide debt burdens. A moderate inflation rate would help reduce nominal debt to GDP ratios. But, with zero inflation, the effective debt burden becomes much harder to reduce.

Very low inflation is also likely to hold back spending and investment. Consumers may prefer to wait before spending – in the expectation prices will continue to fall. Firms may be reluctant to invest given the poor prospects for economic growth. This all contributes to deflationary pressures – which is exactly what the Eurozone should be trying to avoid.

More detail – Problems of deflation

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By on September 12th, 2014

One thought on “EU inflation and deflation

  1. “In one sense a low inflation is good news for consumers who are enjoying low food prices e.t.c. However, the problem is that this low inflation is entrenched and so we are likely to see this leading to wage freezes.”

    Cause/effect here. Inflation is low because consumers do not have money to spend due to austerity inflicted wages freezes and cuts. Business is all about sales, a sale at a lower price is better than no sale at all. It is clearly a vicious cycle however.

    A key factor in the collapse in demand is the extensive property bubble burst across Europe which has resulted in a massive debt-deflation effect. Prices may fall but the value of debts secured against them do not. Interesting that Draghi is finally saying that EU countries should increase spending where possible, too little too late as usual.

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