Draghi on Why the Euro Area Is Not Sliding into Deflation like Japan Did

June 3, 2014

History and economic history is full of rationalizations that “this time is different.”  So it seems to be with the ECB officials, who have defended their policy stance against accusations of the same over-complacency that the Bank of Japan showed in the 1990s as that economy slid gradually into price deflation.  For the record, the ECB refinancing rate was cut just twice during the past 22-months since August 2012, each time (May 2013 and November 2013) by just 25 basis points.  In that time, too, the deposit rate, which had already been at zero, was not moved into negative-rate territory, and the ECB likewise resisted quantitative easing along lines the Federal Reserve, Bank of England and Bank of Japan have practiced. 

Such complacency coincided with falling consumer price inflation.  The full CPI index decelerated from 1.4% in the year to May 2013 to 0.5% one year later.  Non-energy CPI inflation dropped to 0.6% from 1.6%. 

From time to time, President Draghi was asked if the ECB were not guilty of waiting too long and doing too little to guard against deflation, a problem that all agree becomes enormously difficult to eradicate once it takes hold.  Below are his answers as recently as the February press conference and the March press conference.  First February.

The situation is completely different from what Japan experienced at that time in the sense that Japan had deflation and we do not. I already have gone through the long list of reasons why the situation is different, including the monetary policy activism of the ECB at a relatively early stage and the condition of the private sector balance sheets (of both banks and corporates) in the euro area relative to what it was at that time in Japan. But the other thing you said is absolutely right, there are certainly some global factors that keep inflation low. It is not only in the euro area. In the United States, inflation is higher than it is in the euro area, but still low – especially low if one considers the state of their recovery, which is way more advanced than ours.

And then a month later

With regard to comparisons with Japan, I have discussed this before. The situation in the euro area is different because inflation expectations are firmly anchored, whereas they were not in Japan. They de-anchored at some point. You are right, medium to long-term inflation expectations are hard to measure, but this is the measure that the ECB used when inflation was high and is using now that it is low. On both occasions, there have been discussions about the validity of these expectations. They could de-anchor themselves both upwards and downwards, but by and large, they have helped us to deliver, since the establishment of the ECB, our objective of an inflation rate that is below, but close to, 2%. Therefore, the definition of these inflation expectations that we have been using has contributed to our credibility in delivering the inflation target. There are also other reasons why the situation in the euro area is different to that in Japan. First, we have taken early decisive action on the monetary policy front for several years now and are, in fact, still doing so. It has been for several years now that we have continued to take action. You come here every time expecting us to take action and are slightly disappointed when we don’t. However, we are anything but inactive. Second, the condition of the balance sheets of both companies and banks in the euro area today is not what it was in Japan at the end of the 1990s and in the early 2000s. We also monitor other statistical measures, for example, the percentage of commodities or services, of which the prices are falling, i.e. of which price inflation is negative or less than 1%. And the percentages that we are watching are much lower than they were in Japan when the country was suffering from deflation. All in all, we believe that the situation in the euro area is different and that there are other reasons that explain our low level of inflation. I hinted before that global factors are at play, for example low energy prices. The average historical contribution to inflation from energy prices is 0.5 percentage points. More specifically, in early 2012 this contribution was 1 percentage point, while in February 2014, it was -0.3 percentage point. This means that of the 1.9 percentage point fall in annual HICP inflation since the first quarter of 2012, two-thirds can be attributed to lower energy prices. I also mentioned the exchange rate as having an effect. In the case of Japan global factors played much less of a role. There is also another dimension, namely that part of this low inflation is due to relative price adjustments in the stressed countries, which, prior to the crisis, were experiencing serious imbalances that needed to be corrected.

Regarding Japan’s slow response in Draghi’s opinion, bear in mind that the Japanese discount rate was cut from 6.0% at mid-1991 to 1.75% by September 1993 and 0.5% by September 1995.  And a plunge in the overnight Japanese uncollateralized call money rate was also engineered from 8.30% in April 1991 to 3.90% by end-1992, 2.04% in June 1994 and 0.5% in September 1995.  A look at the ECBs response first reveals a 25-basis point tightening of the refinancing rate in July 2008, just two months before the collapse of Lehman Brothers and eleven months after the onset of the global financial market crisis.   From the resulting high of 4.25%, the main refinancing rate was only cut by 1.75% over the rest of 2008.  Even now, some six years after the peak, the refi’s cumulative drop amounts to just four percentage points, clearly less than Japan did.

So when the ECB boasts of being on top of the price stability situation at the upcoming press conference later this week and how much is being now done to guard against deflation, keep this history in mind.  To be really credible, the ECB brass is going to need to renounce all of its hyperinflation hysteria and convince investors of a willingness to accept 3% or higher inflation for a while if that’s what it takes to preserve the European Monetary System and squelch any ember of deflationary expectations.

Copyright 2014, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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