Wolf at the door: Why the eurozone is fearful about the threat of deflation

Watch out, Europe. The big bad wolf of deflation is practically at your doorstep.

Will the continent succumb to the devastating phenomenon of sliding prices? All eyes will be on the European Central Bank (ECB) to see whether it takes any steps to rescue the continent deflation-inflicted destruction.

The latest inflation reading for  the 18-nation currency block showed that prices rose by 0.8% in December, nudging lower from 0.9% in November. Headline inflation is less than half of the ECB’s target of just under two per cent, a level considered reasonable to stimulate economic activity.

While prices are still increasing (but at a slower pace), worries are growing that the eurozone may be on the edge of a deflationary vortex, where prices actually start to fall.

Why are falling prices such a bad thing?

Falling prices, arguably, are a more dangerous economic phenomenon than inflation (rising prices), according to many economists.

Falling prices tend to inhibit consumer spending, as households postpone purchases in the hope that prices will be lower later. With lower demand, businesses tend to defer investments and hiring.

Eventually, wages tumble, leading to even lower consumer spending. Business investments, in turn, fall even further. And the cycle goes on. You get the picture. The economy starts to slowly grind lower.

Slowing economic activity s the last thing a fragile eurozone needs. It barely managed to limp into growth territory in the middle of 2013 after six straight quarters of contraction.

The unemployment rate remains near record levels (above 12%). Bank lending is falling at a record pace. Deflation can only make matters worse.

But the biggest threat of deflation lies in the fact that it increases the real value of debt.

Europe’s peripheral economies, the ones that are the most problematic, are currently struggling with implementing austerity measures that are aimed at reducing heavy debt levels.

Deflation will increase the real value of these debts to crushing levels, choking off growth in the countries that desperately need it the most. While the nominal value of debt remains the same, as incomes decline, a greater proportion of income (individual/corporate) will be used to repay the existing debt.

As this Wall Street Journal blog post notes:Creditors benefit, and debtors lose out. But the problem for the euro zone is that the debtors are concentrated in the slowest-growing, deflation-prone countries, like Greece, Spain, Portugal and Italy, to the south.

“Those already suffering most of the pain will be asked to bear more.”

What can policy makers do? The ECB has already cut its policy rate, the refi rate, to record lows. With the scope and impact of another rate cut highly limited, it will have to resort to out-of-the-box thinking and unconventional monetary tools to keep the predatory wolf of deflation at bay. 

At its policy review meeting on January 9, the central bank opted to keep its benchmark rate on hold. But it is only a matter of time before the ECB is forced to act.

The clock is ticking.

[Image Credit]

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3 thoughts on “Wolf at the door: Why the eurozone is fearful about the threat of deflation

  1. Pingback: Here are four important quotes made by ECB President Mario Draghi recently | Wall of Money

  2. Pingback: Food for thought: The eurozone’s inflation is now below Japan’s | Wall of Money

  3. Pingback: Meet the latest entrant in the list of nations that may get whammied by deflation | Wall of Money

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