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European flags are hung outside the European Commission headquarters in Brussels January 22, 2014. (Yves Herman / Reuters)
European flags are hung outside the European Commission headquarters in Brussels January 22, 2014. (Yves Herman / Reuters)

ECB faces greater pressure to act as inflation forecasts cut Add to ...

Lower inflation forecasts from the European Commission will put more pressure on the European Central Bank to launch measures to prevent falling prices from destabilizing the weak economic revival.

The EC, the executive arm of the 28-country European Union, predicted on Monday morning that euro zone’s inflation rate will land at 0.8 per cent this year and 1.2 per cent next year. Both figures are well below the ECB’s target rate of close to 2 per cent Less than three months ago, the EC had forecast inflation this year at 1 per cent, and at 1.5 per cent next year. The downward revisions came as more evidence emerged that the euro zone’s deflationary pressures are still fully intact, in spite of rock-bottom interest rates, the end of the euro zone’s recession and slightly lower jobless figures.

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The March producer price figures fell by 0.2 per cent over February, marking the third consecutive monthly drop. “The ongoing margin of slack in the manufacturing sector is still clearing limiting the scope for price increases,” said ING Financial Markets economist Martin van Vliet, adding that “ECB president [Mario] Draghi has to keep the door to further easing wide open at Thursday’s news conference.”

The ECB’s governing council meets Thursday to set rates, which are expected to stay unchanged at 0.25 per cent. But at last month’s meeting, Mr. Draghi admitted that a long period of stagnation in the euro zone is his “biggest fear.” The ECB is examining various inflation-busting measures, including quantitative easing and charging interest on commercial bank deposits held by the ECB.

Falling inflation rates (disinflation) can lead to outright falling prices (deflation), either of which can severely damage an economy. Very low inflation or falling prices are a powerful incentive for consumers and business to delay purchases and investments, on the belief that products and services will only getter cheaper. At the same time, disinflation and deflation can sabotage any government’s effort to reduce its debt to gross domestic product ratio. Governments like to use moderate inflation to reduce the real value of debt. Deflation has the opposite effect. It also boosts real interest rates.

Most economists do not expect the ECB to announcing easing measures this week because inflation, while low, is still intact and is forecast to rise somewhat next year as the European recovery slowly gathers momentum. “The euro area inflation outlook remains highly uncertain, but on balance recent trends in leading indicators as well as in spot inflation seem consistent with expectations for some stabilization in inflation,” Deutsche Bank economist Mark Wall said in a Monday note.

The growth rates, however, are insufficient to mop up spare manufacturing capacity or drop the jobless rate quickly. The EC expects the EU to expand by 1.6 per cent this year and 2 per cent in 2015. It expects the euro zone countries to grow by 1.2 per cent this year and 1.7 per cent in 2015, down marginally from its previous forecast of 1.8 per cent.

None of the euro zone countries is in recession, save Cyprus, whose banking system was bailed out last year. The euro zone was in recession in 2012 and 2013.

The EC is worried about external factors weighing down the recovery. “While growth in advanced economies is generally firming, emerging-market economies register a moderate deceleration, and world trade has hit a soft patch amid a continued appreciation of the euro exchange rate,” it said in its spring forecast. “New geopolitical risks have emerged on the back of tensions with Russia.”

While quantitative easing remains an option for the ECB, the Mr. Draghi and some members of the ECB’s governing council have said that designing such a program would not be easy. Quoted in a Reuters story last month, Ardo Hansson, governor of the Bank of Estonia, said “There are a lot of issues that you have to decide. Which types of assets you would start purchasing. By what types of rules? How you would implement that in a decentralized system where there are 18 different central banks implementing monetary policy?”

Follow on Twitter: @ereguly

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