Falling prices in the euro zone has meant deflation has replaced inflation as the most pressing challenge facing policymakers. In February headline inflation, a measure that includes volatile food and energy prices, again turned negative, dropping to minus 0.2 per cent year-on-year. This unexpected decline increases pressure on the European Central Bank (ECB) at its meeting next week to provide a further monetary stimulus to boost the euro zone economy. The headline inflation rate is a key economic indicator which the ECB closely follows when setting monetary policy.
Deflation in the euro zone has been accompanied by slowing growth, reflecting a deterioration in economic sentiment and a decline in consumer confidence, which are likely to depress future spending. Against that bleak background, the ECB may well act on two fronts: increasing negative interest rates to penalise banks that lodge money with it – by charging more for holding those deposits; and increasing its monthly (€60 billion) asset purchase programme. The ECB's efforts to raise bank lending, stimulate growth and increase inflation have met with limited success and diminished its credibility. Political leaders who attended the G20 meeting of the world's largest economies warned of the need to look beyond the current over-reliance on monetary policy measures – low interest rates and money printing by central banks – as the main means of boosting global economic recovery. But they failed to indicate what these measures should be.
The ECB's mandate requires it to achieve price stability which involves a target inflation rate of under 2 per cent. This it has consistently failed to do; as last month's negative inflation rate confirms. Deflation, once established in an economy, becomes hard to reverse. Consumers defer purchases to benefit from falling prices and companies, faced with weak demand, delay investment and reduce their workforce. ECB president Mario Draghi promised in 2012 to do whatever it takes to save the euro. He needs now to stabilise prices and defeat deflation.