Spectre of deflation ramps up threat to stability of euro zone

MEPs gathered in Strasbourg this week for the final plenary session of the current term of the European Parliament before hurrying back to their constituencies ahead of next month's European elections.

High on the agenda was financial regulation as MEPs approved seven financial files, including new rules on regulating the funds industry, revised regulation on the derivatives and capital markets to better protect consumers, and most significantly the Single Resolution Mechanism, the euro zone’s proposed resolution authority for winding up troubled banks.

Unsurprisingly, in light of the financial crisis that gripped Europe from 2008, financial regulation has dominated EU policymaking during the current parliament's lifetime.

Two of the primary figures associated with the handling of the euro zone crisis are stepping down this year as countries prepare to nominate their new EU commissioners following next month's elections. EU economics and monetary affairs commissioner Olli Rehn, a key figure in both the euro zone's controversial economic policy of strict fiscal consolidation and the formation of the various euro zone bailouts, is one of six commissioners standing down from their duties early to contest the European elections.

Michel Barnier, who put his hat in the ring to become the European People's Party (EPP) candidate to head the European Commission, is also stepping down. Since succeeding Charlie McCreevy as internal markets commissioner the Frenchman has spearheaded a raft of measures to tighten up regulation of the European banking and financial sectors. But while Barnier was keen this week in Strasbourg to stress the achievements of his directorate general over the last five years, significant threats to euro zone financial stability remain.

Deflation fears
Yesterday, official figures showed inflation in the euro zone fell to its lowest level in more than four years, reigniting fears that Europe could be heading towards deflation.

Inflation across the euro zone fell to 0.5 per cent in March, compared with 0.7 per cent in February, and 1.7 per cent a year ago, strengthening the case for further intervention by the European Central Bank when its governing council meets next month.

Last weekend the bank indicated it might be prepared to take action to tackle the persistently low inflation rate across the 18 euro area countries. A further cut in interest rates is likely to take precedence, with holders of tracker mortgages in line for a further drop from the already record low of 0.25 per cent. Speaking at the International Monetary Fund's spring meeting in Washington, ECB president Mario Draghi said strengthening the euro "requires further monetary stimulus", suggesting the bank could be prepared to cut one of its key interest rates to below zero.

Non-conventional measures
More significantly, the ECB looks increasingly likely to resort to so-called "non-conventional measures" such as quantitative easing as its room for manoeuvre on interest rates narrows. More than 18 months after Draghi pledged to do "whatever it takes" to preserve the single currency, the possibility of Outright Monetary Transactions has served to calm markets without ever being activated.

Now it seems that the tool that was conceived as a means to tackle financial crises in stressed countries may be used to tackle the threat of deflation and kick-start the euro zone’s anaemic growth.

The sense that Germany is gradually warming to the idea of bond-buying also makes the possibility of deployment more likely, with Bundesbank chief Jens Weidmann indicating late last month that the ECB would consider purchasing euro zone government bonds or private sector assets. Market watchers have stressed that the notoriously hawkish Frankfurt-based bank is still not convinced of the need to follow the US Federal Reserve's example and buy billions of euro of debt.

The strong performance of peripheral debt markets in recent months, which has seen the government bond yields of countries such as Ireland, Portugal and Spain fall sharply, has given a boost to euro zone policymakers. Ireland's smooth return to private market funding, Greece's return to bond markets last week and the possibility that Portugal may exit its bailout programme without the help of a precautionary credit line indicates the worst of the crisis has passed.

But while the threat of a euro zone break-up has receded, the zone is facing deeper, more entrenched economic challenges, including falling inflation, extremely high unemployment levels and weak economic growth. Large economies such as France and Italy are still struggling to meet budget deficit reduction targets set by Brussels.

Rehn’s successor will have much work to do when he or she assumes responsibility later this year for what remains the European Commission’s most important division.