Euro Area — “Deflation” Versus “Lowflation”

IMF Blog, March 4, 2014

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Although inflation—headline and core—has fallen and stayed well below the ECB’s 2% price stability mandate, so far there is no sign of classic deflation, i.e., of widespread, self-feeding, price declines.
Even ultra low inflation—“lowflation”—can be problematic for the euro area as a whole and for financially stressed countries, where it implies higher real debt stocks and real interest rates, less relative price adjustment, and greater unemployment.
Japan’s experience, which saw deflation worm itself into the system, argues for a more pre-emptive approach by the ECB.

Mario Draghi’s characterization: deflation involves price level declines that occur (1) across a significant number of countries; (2) across a significant number of goods; and (3) in a self-fulfilling way.
Geographical scope:
- Recent price changes have been positive in all but 3 countries (versus 12 countries as recently as 2009).
Incidence across goods and services:
- Outright price declines account for only a fifth of the HICP basket — not a high share and no more than in 2009.
Self-fulfilling dynamics and expectations:
- Expected inflation 5-10 years out is flat and so could not possibly be the cause of falling current inflation.
- 2-4 year ahead expected inflation is falling and could be affecting current inflation.
- Actual inflation stabilized in February at 0.8%.

Problem #1:
- Both deflation and less-than-previously-expected inflation increase the real burden of existing debt and the real interest rate that borrowers pay.
- The countries with deflation/low inflation also happen to be the ones with already higher debt burdens (private + public) and real rates, and include all the countries that have been under market pressure during the crisis.
Problem #2:
- When inflation turns low everywhere in the euro area, each unit of deflation/low inflation endured by indebted countries delivers less price adjustment relative to surplus countries.
- Each point of relative price adjustment must be bought at the cost of greater debt deflation.
Problem #3:
- With sticky nominal wages, any ongoing inflation cushions the hit to unemployment by lowering real wages firms pay.
- In Spain after the crisis, the wage distribution slammed against the zero-barrier, with 30% of the distribution concentrated there.
- Given sticky nominal wages, near zero inflation in Spain is not helping to resolve the severe unemployment problem there.

Lesson #1:
- Do not take too much comfort in long-term inflation expectations being positive (over 2% in the euro area).
- Long-term expectations on the eve of three deflationary episodes in Japan were also reassuringly positive, but nearer-term expectations turned more pessimistic, feeding into spending and wage decisions and delivering actual deflation.
- Not-so-long-term inflation expectations need to be given due consideration.
Lesson #2:
- One needs to act forcefully before deflation sets in.
- The Bank of Japan was relatively slow in lowering policy rates and ratcheting up base money and had to resort to ever-increasing stimulus once deflation set in; that effort has continued for two decades.

Very low inflation may benefit some groups (notably net savers) but, in the current context of widespread indebtedness, it detracts from recovery in the euro area and harms fragile countries by thwarting debt reduction, competitiveness restoration, and unemployment reduction.
Policy recommendations for the ECB:
- Be sure that policies are equal to the tasks of reversing the downward drift in inflation and forestalling the risk of a slide into deflation.
- Consider further cuts in the policy rate.
- More importantly, look for ways to substantially increase its balance sheet, be it through targeted LTROs or quantitative easing (public and private asset purchases).

Reza Moghadam, Ranjit Teja, Pelin Berkmen — March 4, 2014