Fears as euro zone inflation falls again

Japanese-style deflation couldderail bloc’s fledgling recovery

Inflation in the euro zone hit its lowest level in more than four years in March, stoking fears that the currency bloc is drifting towards a damaging period of falling prices.

Eurostat, the European Commission’s statistics bureau, estimated that inflation slowed to 0.5 per cent last month, its lowest level since November 2009.

The lower-than-expected inflation number is in part the consequence of last year's early Easter – a time when businesses tend to raise their prices. But, taken together with the most recent batch of readings, Monday's figure is only the latest sign that price pressures in the euro zone have been more subdued than economists had forecast. It also strengthens the case for the European Central Bank's governing council to loosen monetary policy when it meets on Thursday. "The risk of de-anchoring inflation expectations is rising," said Philippe Gudin de Vallerin, chief European economist at Barclays. "The ECB can argue that it's a base effect. But if you look at the trend since last summer, they've been revising inflation down and down."

Global phenomenon
Disinflation is, in part, a global phenomenon: price pressures in the UK and the US have also dipped below central banks' targets as the weak global recovery has left a large amount of spare capacity across advanced economies. Anaemic demand has also helped contain energy prices. The drift downwards has prompted IMF managing director Christine Lagarde to dub deflation as "the ogre that must be fought decisively". But inflation in the euro zone has slipped further in the currency bloc than in the US, where it is 1.1 per cent, and in Britain, where it is 1.7 per cent, partly because there is far more spare capacity here than elsewhere.

The strength of the euro, which edged up against the dollar yesterday despite the drop in inflation, has also kept price pressures subdued by lowering the cost of imports. ECB president Mario Draghi has said the appreciation of the euro between 2012 and today knocked about 0.4 or 0.5 percentage points off inflation.

Labour costs
The ECB has claimed that some of the disinflation is good news, coming on the back of a drop in relative labour costs in peripheral economies that has made weaker member states more competitive. But even in Germany, the bloc's largest and most competitive economy, inflation is only 1 per cent – about half of the central bank's target of just below 2 per cent.


Economists warn that, if the euro zone was to suffer from a Japanese-style deflation, this could derail the bloc’s fledgling recovery by weakening demand as businesses and households put off purchases in the expectation that prices will carry on falling. Debt burdens – which are fixed in nominal terms – would also increase in a scenario of falling prices.

Inflation across the currency bloc is set to accelerate closer to 1 per cent next month after the effect from last year’s early Easter disappears and companies raise their prices ahead of this year’s holiday. Still, the ECB expects inflation to remain below its target at least until the end of 2016.

ECB policymakers have recently signalled they could back more radical measures, such as quantitative easing and negative deposit rates.
– Copyright The Financial Times Limited 2014