The ECB Should Act to Avert the Risk of Deflation in the Euro Area

For years, observers of the European Central Bank (ECB) have been hearing the same line from its former President, Jean Claude Trichet: “We have one needle in our compass, and that is price stability.” This precept should contribute to understanding the central bank’s policy stance: When price stability is assured, there is no need to change policy. When price stability is at risk, policy should be changed to fulfill the mandate.

But what exactly is price stability? The Maastricht Treaty establishes price stability as the primary objective of the ECB but does not define its meaning. The ECB’s Governing Council has announced a quantitative definition of price stability. In the ECB’s own words, "Price stability is defined as a year-on-year increase in the Harmonized Index of Consumer Prices (HICP) for the euro area of below 2 percent.” The Governing Council has also said that, in the pursuit of price stability, it aims to maintain inflation rates below, but close to, 2 percent over the medium term.

This has been a clear constant for the nearly decade and a half of the ECB’s existence. Achieving 2 percent inflation has been portrayed as a show of success. In fact, the ECB’s leadership has often reminded markets, colleagues, and academics of their impressive record, noting that, until recently, inflation in the euro area has averaged 2 percent since the ECB’s inception.

But that was the past. Is the euro area now facing a period of downward price instability? The recent combination of data and policies is introducing a legitimate fear of disinflation. Following several months of deceleration, annual inflation in the euro area was a mere 1.2 percent in April, down from 2.6 percent a year earlier, showing a clear underlying disinflationary trend.

Figure 1

In fact, services inflation, which traditionally is a good proxy for underlying inflationary trends, was just 1.1 percent. Greece is already in deflation, and 5 other countries have inflation below 1 percent. Another four countries have inflation between 1 and 1.5 percent. One of these, Germany, the country that should be compensating the expected low inflation in the periphery countries, is running an inflation rate of just 1.1 percent.

Figure 2

Inflation in the euro area is in a clear downward trend—and, sadly, this is not unexpected. The reason is that the euro area has spent the last few years in a low growth path combined with policies that have not only been tight, but also in some countries targeted at producing disinflation. Let’s not forget that a cornerstone of the recent policy mix in the euro area has been to achieve an internal devaluation: a reduction of wage growth, combined with structural reforms, to try to regain competitiveness. And, in fact, as a result of labor market reforms, wage growth has collapsed in some traditionally high wage growth countries, such as Spain, where wage growth fell to essentially zero in 2012. The resulting combination of tight fiscal, regulatory, and credit policies has suppressed demand in the euro area, leading to an output gap estimated at 3 percent of potential GDP by the IMF, and a poor growth outlook for the next few years, implying an inflation forecast that is unlikely to return to 2 percent in the next few years.

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