Two years ago, in late 2014, the spectre of deflation loomed large in the Eurozone economy. The Eurozone’s headline inflation rate had been sliding steadily downwards since 2011 and slipped into negative territory in December 2014 and didn’t return to positive until May 2015. Since then, it has remained close to zero, occasionally slipping back into deflation. Only in late 2016 did impetus return to inflation, with the latest figures showing an annualised rate of 1.8% in January 2017.
A prolonged low rate of inflation has serious implications for monetary policy because it introduces the threat of a deflationary spiral. Under normal circumstances the main stimulus tool for central banks is their ability to influence the real (inflation-adjusted) interest rate via their control over the short-term nominal interest rate. In the relationship described by the Fisher equation, the real interest rate is approximately equal to the nominal interest rate minus the rate of inflation or, if we incorporate agents’ expectations (since they form the basis of investment and hiring decisions), the expected rate of inflation.
A prolonged low rate of inflation has serious implications for monetary policy because it introduces the threat of a deflationary spiral.
In theory, reducing the nominal interest rate should lower the real interest rate via this mechanism, which in turn should boost economic activity and generate inflation. However, once interest rates have been taken to their lower bound – as the have in the Eurozone – the floor of the real interest rate is determined by the expected rate of inflation. And since economic agents use current inflation, as well as historic data, to form their inflation expectations, a prolonged period of low inflation will lead to low inflation expectations. This all implies that a long period of low inflation with interest rates at their lower bound can render conventional monetary policy methods futile since they cannot reduce the real interest rate enough to pep up demand in the economy.
This is a dangerous situation to be in because if inflation slips into negative territory, the economy may enter a deflationary spiral where the central bank is unable to increase expected, and therefore actual, inflation. This prevents the real interest rate from falling further, depressing economic activity and leading to more deflation.
Arguably, deflation is worse than inflation for a number of reasons. Firstly, falling prices reduces aggregate demand as both businesses and consumers postpone investment and spending. Secondly, it may entrench the Eurozone’s high rate of unemployment because without positive inflation, wage stickiness prevents real wages from adjusting in the labour market – in the Eurozone, certain states have strict employment protection legislation and high union coverage that may reinforce these rigidities. Thirdly, deflation can make relative price adjustment more difficult. Producers in “periphery” countries, such as Greece, Spain and Portugal, who have lost competitiveness will be unable to lower relative prices in real terms via freezing nominal prices; instead they are forced to cut prices and wages, leading to slower growth. Finally, deflation has worrying implications for the sustainability of debt, both public and private, which is particularly relevant to the highly leveraged Eurozone economies.
Arguably, deflation is worse than inflation
Against this backdrop of severe disinflationary forces pushing inflation close to zero, the ECB – whose policy mandate is to keep headline inflation close to 2% – decided in late 2014 to embark on a programme of quantitative easing in order to bring inflation back to its target level. In March 2015 the ECB commenced its quantitative easing programme – the Expanded Asset Purchase Programme (EAPP) – which involved spending €60 billion a month up until March 2016. From April 2016, monthly purchases increased to €80 billion.
Under EAPP, the ECB has created new money to purchase euro-denominated, investment-grade securities issued by European governments and institutions. The policy is intended to stimulate output and inflation via several transmission channels. First, providing banks with extra liquidity should increase the availability of credit in the economy, providing a boost to demand. Second, by investing in a large quantity of bonds, the central bank signals to markets its commitment to keep interest rates low in future (because raising them would reduce the price of the bonds it holds, causing the ECB to incur a loss). Third, low interest rates on European bonds will prompt investors to look abroad for better for returns, reducing demand for euros and contributing to a currency depreciation that should stimulate exports.
Against this backdrop of severe disinflationary forces pushing inflation close to zero, the ECB decided in late 2014 to embark on a programme of quantitative easing
Initially it seemed that the programme was successful: in May 2015, the third month of bond purchases, inflation reached a peak of 0.3%. However, this rise in inflation was short-lived and thereafter inflation drifted between -0.1% and 0.3%, only exceeding 0.3% in September 2016. Furthermore, while the recent increases in inflation suggest that EAPP may finally be working, the measure of core inflation – which strips out food and energy costs – has remained stable at 0.9%, the same as it was in June 2016, suggesting that the uptick in overall inflation is more a result of rising energy costs than the effects of recent ECB monetary policy measures.
Therefore, if we are to use inflation as a benchmark to measure the success of EAPP, the policy has fallen short of its objectives: inflation has been well below the target rate throughout the duration of the programme and only in the last few months, as energy prices have rebounded, has inflation begun to increase again. Yet, in the context of the numerous deflationary pressures buffeting the Eurozone economy, we cannot judge recent ECB policy measures to have failed completely. While EAPP has been unable to increase inflation substantially, it has helped prevent inflation expectations from falling too far by reassuring markets of the ECB’s commitment to reach its target, thus helping to prevent a deflationary spiral. Consequently, it may be more constructive to evaluate the effectiveness of EAPP in terms of what it prevented as well as what it achieved. And from this perspective, we can conclude that although EAPP has not been the reflationary silver bullet that some had hoped for, it has been an essential plank in the ECB’s efforts to ward off the spectre of deflation.