Euro Area Inflation Justifies More ECB Stimulus

March 4, 2014

Officials on the ECB Governing Council often assert that their’s is a policy that addresses the average economy of the whole bloc, not one or more of its component parts.  However, the revealed predisposition of the policymaking committee suggests that policy is directed primarily to inflation and prospective future inflation in Germany. 

The central bank’s mandate is to secure inflation in the medium term that is close to, but slightly below, 2.0% for the total consumer price index.  Ezone consumer prices climbed 2.0% in the year to January 2013 followed by 0.8% in the year to January 2014.  The German weight in this index is 0.277, while the weight for the other 17 members is collectively 0.723.  German harmonized CPI inflation fell only 0.3 percentage points from 1.5% in January 2013 to 1.2% in January 2014, and the acceleration of German economic growth points to inflation in 2014 of between 1.6% and 1.8%, more or less consistent with the target.  There were two 25-basis point cuts of the ECB refinancing rate in 2013, administered six months apart in May and November, but neither was accompanied by a lowering of the deposit rate.  For Germany this was certainly accommodative enough, maybe a little bit more than needed, but bear in mind that German real GDP increased only 0.7% in 2012 followed by 0.4% in 2013.  Even in Germany’s case, one could argue that a greater amount of monetary accommodation would not have been unreasonable, especially since the firmer-than-expected euro constituted a de facto tightening of monetary conditions.

The ECB’s monetary policy for the other 72-1/4% of the common currency area is truly indefensible, which is why I’m expecting some easing on Thursday.  For these 17 economies, on-year CPI inflation collectively fell from 2.2% in January 2013 to 0.65% in January 2014.  In ten of those countries, inflation is positive but less than 1.0%.  In Belgium, it is at 1.1%.  In Greece, CPI inflation was at zero in January 2013 and is now minus 1.4%, and in Cyprus inflation collapsed 3.6 percentage points from 2.0% in January 2013 to negative 1.4% one year later.  Four economies still have inflation of at least 1.5% — Austria and Luxembourg at 1.5%, Estonia at 1.6% and Finland at 1.9% — but there collective weight in Euroland’s CPI index is only 5.7%.  No member’s inflation is above 1.9%, meaning there are no instances of above-target inflation and 17 out of a possible 18 members experiencing sub-target inflation.

How close to deflation (jargon for a general fall in prices) might the 0.65% current collective rate for non-Germany Euroland be?  The earliest instance of consecutive months with sub-zero on-year CPI inflation in Japan occurred in March and April of 1995.  Two months earlier in the year to January 1995, consumer prices had risen by 0.6%.  Japanese officials back then, like present-day maestros of ECB policy, denied the danger of entrenched deflation.  History instructs that it’s harder to end a deflation than an excessive inflation.  The implication is that if more euro area economies slide below zero inflation, it will be much more likely that they will drag inflation in the rest of the bloc downward than that those with inflation already above 1.0% lifting those economies with falling prices out of their deflationary hole.

It would have been better if the ECB had attached excessively low inflation more preemptively.  The conclusion revealed by the Governing Council is that policymaking has in fact been politicized with Germany commanding more influence than its actual weight should have allowed.

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



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