Euro Zone's Low Inflation Results for May: Can ECB Stave off Deflation?

This week the ECB will announce their decision on the level of interest rates that are to apply in the Region.  Currently the rate that makes headline news is the refinance rate which stands at 0.25% and which was reduced from 0.5% in November 2013.

The aim of interest rate policy is to maintain inflation at or a little below 2% per annum over a two year period.  Currently the inflation rate for the Euro area is 0.5% with Germany announcing a rate of 0.6% and Italy a rate of 0.4%. The rate is well below the 2% target of the ECB and is causing much concern among policy makers and commentators alike.  It might be asked why we are worried about a low rate of inflation when the authorities have been fighting too high levels since the seventies when inflation was rampant. 

The problem with a low rate of inflation is that it is moving into deflation territory when prices are found to be falling rather than rising.  This is likely to cause economic decisions to be deferred as purchasing goods later may be at a lower price than today.  The result is, at best, stagnation or falling production.  As Japan has found out since it went into a deflationary state in the early nineties this is a very difficult situation to reverse and is one to be avoided.

Commentators believe the current situation of low inflation has been brought about by the European reaction to the financial crisis in 2008.  Led by Germany the approach was to impose austerity measures on those countries in crisis such as the ‘PIIGS’ or Portugal, Ireland, Italy, Greece and Spain.  They also imposed strict regulations on their banks which involved them maintaining a much higher level of capital to support their loan book and to curtail, previously, very profitable high risk activities in their investment banking arms.  The plan was to make the banks capable of supporting themselves in future financial crises so that nation states were not used to bail them out.  The result was to cut back severely on liquidity and reverse economic growth.  Other areas such as the US and UK countered the deflationary influence of these actions by pumping money into their economies through quantitative easing and keeping a very loose monetary policy with historically low interest rates.  Europe was nervous of the inflationary potential of such a policy so did not follow the same path.

One option that they have would be to suspend the Securities Market Program (SMP) and introduce a longer version of its long term refinancing operations (LTRO) program. The SMP was put in place 4 years ago whereby for every euro that the bank spent buying government bonds of the PIIGS it also withdrew an equivalent sum from the banks through interest bearing deposits, thereby offsetting purchases in order to keep the money supply stable.  This process is known as sterilisation because they are actually taking the money back out of the market.

If the ECB stopped this process the money would stay in the banking system and the hope would be that this

excess cash would be lent to other banks thus reducing short term interest rates and encouraging banks to loan to households and businesses.  It would also act as a signal that the ECB is prepared to undertake QE if necessary. However there is no guarantee that the banks will lend more to each other, they could simply just reduce the amount that they borrow from the ECB’s normal facility.

The LTRO program involves the ECB lending money at a very low interest rate to banks within the Eurozone to enable them to buy higher yielding assets as well as to lend to households and businesses.  Previously these loans had to be paid back at time periods of between 3 and 12 months, however the ECB introduced new 3 year LTROs in December 2011 which proved popular. Banks were able to use sovereign bonds as collateral for the loans which benefited those countries where the bond yields had reached unsustainably high levels that jeopardised future repayments.

 

The ECB is still restrained from taking the same path as the US and UK and is seeking alternative solutions such as that described above but only if the economy continues to show little sign of recovering more strongly.

The favourite expectations of what they will do when they announce policy this Thursday is to cut the refinancing rate, currently standing at 0.25% to 0.10% and to charge the banks for leaving excess deposits with the ECB.  This, currently, stands at zero percent but may be cut to –0.10% thus encouraging the banks to make better use of the funds by lending it on to households and businesses.

It is not certain, however, that these moves would be the solution as the rates involved are very small and may not be sufficient to influence banks, businesses and consumers to change their behaviour.  It would have some influence on confidence but this is a two edged sword and could lead to the perception that the ECB is short of ideas and tools with which to tackle the situation.  Such a reaction could hasten the move towards deflation.

One major result of such action could be to reduce the value of the Euro which has been very strong with investors happy to place their funds into a currency that was supported by a vastly improved political environment since the stabilisation of the finances of the PIIGS.  A fall in the Euro would remove the deflationary pressures caused by a strong Euro on imported prices.

Mario Draghi the ECB President has indicated that lower deposit and refinancing rates will be on the agenda this week but that a decision to move rates would depend in large part on the economic statistics that are announced this week.  These include the inflation figures from Germany which has come in at 0.6% for the year with a fall of 0.3% in the month of May and Italy reporting a 0.4% rate of inflation.  The rate of unemployment in the EuroZone, however, fell from 11.8% to 11.7% but with a range of 4.9% in Austria to 26.7% in Greece this will be difficult to control while austerity remains essential in areas like Greece.  Manufacturing activity came in showing growth in the bloc as a whole but France continued to be in contraction.  The statistics continue to show the wide range of performances and the difficulties of having a policy to cover all countries but there remains a need for action to boost activity in, what is a large part of the global economy.