Deflation

The governing council of the European Central Bank meets on Thursday amid rising expectations in the market that it will signal another easing in monetary policy, either in February or March. Most ECB watchers now expect the council to cut the refinance rate by around 15 basis points before quarter end (from 0.25 per cent to 0.10 per cent), and some expect the deposit rate to be reduced into negative territory for the first time. This action would be in response to recent volatility in money market rates, and an unexpectedly low inflation rate of 0.7 per cent for the euro area in January.

If the ECB was to follow this course of action in the next couple of months, it would represent another relatively minor adjustment in its policy stance in response to surprisingly low inflation data. It is still thinking in terms of incremental changes in policy, rather than anything more dramatic. This, of course, follows from the fact that the ECB has a pessimistic view of the growth in potential output since 2008, implying that the output gap is fairly small, and that inflation in the medium term will gradually return to the target of “below but close to” 2 per cent.

This view is, however, being increasingly challenged by the data. Some forecasters now see the 12-month inflation rate falling to only 0.5 per cent in the spring, depending on the behaviour of oil prices. More importantly, core inflation also continues to drop. After the next round of interest rate cuts, the central bank will genuinely be at the zero lower bound for the first time ever. The ECB will therefore face a major problem if the inflation data confound again, and head towards zero. Read more

In recent months, inflation has again reared its head as a problem in the developed economies. But this is not because it is too high. In most countries, headline CPI inflation has been falling significantly since the end of 2011, and it has now dropped to less than 1 per cent in both the US and the euro area.

Furthermore, the pervasive decline in headline inflation has been accompanied by a similar decline in core inflation rates, which are also hovering at worryingly low levels in most countries. In fact, out of the 25 developed economies that publish regular data on Haver Analytics, only Iceland is currently experiencing an inflation rate that could be considered markedly too high by any of these measures. Read more

The Federal Reserve broke a taboo yesterday when it said quite baldly that inflation in the US is now below the level “consistent with its mandate”. In other words, it is too low. This is a very big statement for any central banker to make, since the greatest feather in their collective cap is that they successfully combated inflation after the 1970s debacle.  Read more

The battle to avoid deflation in the developed world could prove to be a long one, with twists and turns which could last for many years. In July, the core CPI data in the eurozone were somewhat firmer than expected, as were the core PPI data in the US. This has led some economists to suggest that underlying price pressures are beginning to rise again, and that the deflation scare is over. Would that that were true. Some interesting new evidence from the IMF suggests that while outright deflation might be avoided, at least for a time, the developed economies could soon get stuck in a kind of limbo land, with inflation remaining unhealthily close to zero for a very long period. Read more