As deflation looms, aggressive QE may be too little, too late from ECB

Share

The European Central Bank is under fire for failing to take more aggressive measures to stimulate the economy as plummeting inflation in the euro zone turned into outright deflation in December, jeopardizing the fragile recovery.

Several economists and market strategists said the 0.2-per-cent annualized decline in consumer prices in the 19-country euro zone could not be attributed entirely to the 55-per-cent drop in oil prices since June.

The ECB, they implied, could not have been surprised by the negative inflation number and could have launched full-blown quantitative easing in the autumn. The central bank, led by president Mario Draghi, is now expected to do so at the next policy meeting, on Jan. 22, or shortly thereafter.

Jeremy Cook, chief economist at foreign exchange company World First, said in a research note that "what today's number has done is show the alarming lack of foresight that the ECB has exercised once again, and how close to the fire the European economy remains."

Euro zone inflation has been under 1 per cent, and falling, for more than a year. The December reading marked the first year-on-year fall since October, 2009, when the region was in a deep recession triggered by the financial crisis. The deflation figure released by Eurostat, the European Union's statistics agency, was worse than expected, as economists had forecast a 0.1 per cent fall in prices.

Nicholas Spiro, managing director in London of debt consultancy Spiro Sovereign Strategy, said the deflation figure does not reflect well on the ECB.

"For a central bank whose sole mandate is to maintain price stability by meeting its inflation target of just below 2 per cent, this is a severe blow to the credibility of Europe's monetary guardian. The onset of deflation in the euro zone is psychologically damaging, underscoring the severity of Europe's economic downturn and accentuating the 'Japanization' of the bloc."

While overall euro zone inflation was negative, core inflation, which excludes typically volatile energy and food prices, nudged up marginally to 0.8 per cent, year-on-year, giving the ECB a small measure of hope that the 0.2-per-cent deflation reading is a blip and not the start of a trend. Deflation can severely damage an economy if consumers and businesses think that prices will fall for some time. When that happens, the incentive is to delay purchases in the expectation that a product or service will become cheaper.

But with oil prices apparently unable yet to find a bottom, weak demand throughout the euro zone and continued high employment, some economists doubt the core inflation figure will tick up. ING Financial Markets economist Teunis Brosens said that "with substantial spare capacity in the euro zone, there is no reason whatsoever to assume this is the beginning of an upward trend."

The euro zone's excess spare capacity was highlighted Wednesday by fresh data showing unemployment stuck at 11.5 per cent in November. The figure, while high, masked substantial variations across the region. Unemployment in Italy, the third largest economy, hit a record 13.4 per cent in November while youth unemployment climbed slightly to 43.9 per cent. But German unemployment fell to a record low of 6.5 per cent in December, reinforcing fears that the euro zone is firmly divided between the relatively wealthy north and the increasingly poor south.

If Mr. Draghi launches full-blown quantitative easing in the next month or two, it may be too little too late as low oil puts continued downward pressure on prices. A limited form of quantitative easing, in the form of the purchase of covered bonds and asset-backed securities, was introduced in the autumn, to little effect. Inflation kept falling. Even negative interest rates implemented by the ECB – charging banks to park overnight money at the bank – failed to do the trick.

John Muellbauer, economics professor at Oxford University, thinks U.S.-style quantitative easing is unlikely to have the same success in Europe as it did in the United States. In an analysis carried by the Voxeu.org economists' site last month, he observed that in Germany and in France, total liquid household assets are far larger than household debt, "so much so that lower policy rates translate into lower deposit rates, and reduce total household spending – the opposite of what occurs [under quantitative easing] in the U.S. and the U.K."

He also found that Europeans are less invested in the stock market than Americans. In the United States, quantitative easing helped to lift share values, boosting consumer spending. The effect of share price rises in Europe would be muted in comparison. If the ECB is to print money, he suggests a more efficient way to boost the economy would be through depositing a handout of €500 in the bank accounts of adult citizens.