TODAY’S figures from Eurostat confirmed what the markets had expected following reports already out from Spain and Germany: consumer prices are now falling across the euro zone. Inflation turned negative in December, with prices down by 0.2% on their level in December 2013. This is the first time that the euro area has experienced deflation since 2009, when headline inflation went below zero for five months (from June till October).
As was the case in 2009, the slide into deflation has been caused by the oil-price slump as it feeds through to energy prices. “Core” inflation (which excludes energy, food, alcohol and tobacco), actually edged up in December to 0.8%, from 0.7% in November.
Deflation can be good or bad, depending upon what is driving it and how long it lasts. A short burst of deflation associated with an oil-price fall is good, since it acts as a tax cut, boosting consumers’ real purchasing power. That’s a timely boost for the moribund euro-zone economy. Although the single-currency club appears to have avoided outright recession in 2014, growth became so anaemic that it made little difference. Purchasing-manager indices of activity in the services and manufacturing sectors in the final three months of 2014, compiled by data-firm Markit, were the weakest since the third quarter of 2013, suggesting that growth remained feeble in late 2014.
Deflation is bad, if it persists and people and businesses come to expect prices to fall. That can lead to slacker spending since it makes sense to postpone purchases and pay lower prices at a later juncture. A prolonged period of deflation would be crippling for the euro zone because both public and private debt are extremely high in parts of the region. The real burden of debt, which is generally fixed in nominal terms, rises when prices fall.
The worry about the euro zone slipping into deflation is that it could reinforce already low inflation expectations or lower them further. A brief burst of good deflation driven by the oil-price fall could become a sustained period of bad deflation based on underlying weakness in the euro-zone economy and expectations that prices may continue to fall.
The onset of deflation in the euro zone thus has both a bright and a dark side. The way to accentuate the bright side and to avoid the dark side is to provide firmer assurance to businesses and individuals that the period of falling prices will be short-lived and that inflation will return towards the European Central Bank’s objective of just below 2%. The clearest way in which the ECB can show that it means business would be to announce a big quantitative-easing programme when its governing council meets on January 22nd.
