PARIS – “Having said that deflation in the United States is highly unlikely,” outgoing Federal Reserve Chairman Ben Bernanke famously remarked in 2002, “I would be imprudent to rule out the possibility altogether.” At that time, annual inflation in the US exceeded 2%, and the risk of it becoming negative was indeed remote; but Bernanke nonetheless felt it necessary to map out an escape route from a potentially catastrophic scenario. The response that he described was essentially a preview of the policies that the Fed implemented in the aftermath of the 2008 shock.
For the eurozone today, the threat is not remote. According to the latest inflation data, annual consumer price inflation is just 0.9% (and 1% if volatile energy and food prices are excluded). That is one percentage point below the European Central Bank’s target of “below, but close to, 2%.” With the economy clearly operating below full capacity and unemployment above 12%, the risk of a further decline cannot be excluded, especially given downward pressure from a gradually appreciating exchange rate and a global context of negative growth surprises and subdued commodity prices. So it is past time to recognize the deflation danger facing Europe and to consider what more could be done to prevent it.
The first problem with deflation is that it tends to raise the real (inflation-adjusted) interest rate above its equilibrium level. As there is a zero lower bound to the nominal interest rate, the central bank may well find itself unable to drive the interest rate/inflation differential to a low enough level, which may result in a slump and even a downward spiral. True, some central banks (Sweden in 2009 and Denmark in 2012) have charged banks for taking deposits, thereby posting negative interest rates. But there are limits to such tactics, because if depositors are being charged, at some point it becomes preferable for them to buy safes and store banknotes.
This problem is highly relevant for the eurozone, which is emerging from a long recession, with GDP still below its 2007 level and the recovery, though real, still lacking momentum. Having recognized the danger, the ECB has lowered its benchmark interest rate twice in recent months, to 0.25%. The problem is that this may be too little too late to move the real interest rate to where it should be in order to foster sufficiently strong enough economic recovery.
The second problem with deflation is that it makes economic rebalancing within the eurozone much more painful. From October 2012 to October 2013, inflation was negative in Greece and Ireland, and zero in Spain and Portugal. But these countries still need to gain competitiveness by lowering the relative price of their export goods, because they need to sustain external surpluses to correct accumulated imbalances. With average inflation in the eurozone hovering near zero, these countries face a very uncomfortable choice between lack of competitiveness and even deeper domestic deflation. Average inflation that is too low amounts to sand in the wheels of eurozone rebalancing.
Last but not least, deflation increases the burden of past debt. Unlike equity, a debt security is a nominal claim whose value does not vary depending on the inflation rate. With deflation leading to negative income growth, the weight of debt relative to income increases, potentially becoming unbearable for borrowers – and thus increasing the risk of sovereign- and private-debt crises.
Once upon a time, this “debt deflation” scenario was merely a case study for macroeconomics students. Not anymore. As a result of deflation and recession, GDP (in current euro prices) in Greece, Ireland, Portugal, and Spain is at the same level today as in 2005 or 2006. For this reason, and despite all their deleveraging efforts, the legacy of past failings still weighs heavily on these countries’ economies.
The ECB’s recent interest-rate cuts clearly reflect its concern about these risks. Indeed, it expects a prolonged period of low inflation, followed by a gradual upward movement toward its target, with downside risks to this scenario. Accordingly, it expects its main policy rate to remain at the current 0.25% level or be brought to zero.
But, while the ECB cannot be accused of neglecting the deflation risk, the difficulty with its stance is that keeping annual inflation at around 1% and hoping for a delayed and gradual ascent is hardly enough. Not only does it run counter to what the ECB has been mandated to achieve; it also implies too small a buffer in the event of a further deflationary shock; leaves too much sand in the wheels of Eurozone rebalancing; and makes deleveraging in high-debt countries unnecessarily painful.
Can the ECB do more? Having acted boldly since the summer of 2012 to preserve the Eurozone’s integrity, it has felt compelled not to antagonize policy hawks and to err on the side of caution in formulating its monetary strategy. This is an uncomfortable middle way.
Alternatively, the ECB could put political correctness aside and do more to fulfill its price-stability mandate by spelling out a strategy to return to normalcy, and by indicating an unambiguous readiness to adopt an explicit list of unconventional policies.
The point is that the ECB must be prepared to make that choice. As Bernanke can attest, conventional monetary policies may stop working sooner rather than later.
Jean Pisani-Ferry teaches at the Hertie School of Governance in Berlin, and currently serves as Commissioner-General for Policy Planning in Paris.
Copyright: Project Syndicate, 2013.