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Europe’s Real Inflation Problem

PARIS – “Having said that deflation in the United States is highly unlikely,” outgoing Federal Reserve Chairman Ben Bernanke famously remarked in 2002, “I would be imprudent to rule out the possibility altogether.” At that time, annual inflation in the US exceeded 2%, and the risk of it becoming negative was indeed remote; but Bernanke nonetheless felt it necessary to map out an escape route from a potentially catastrophic scenario. The response that he described was essentially a preview of the policies that the Fed implemented in the aftermath of the 2008 shock.

For the eurozone today, the threat is not remote. According to the latest inflation data, annual consumer price inflation is just 0.9% (and 1% if volatile energy and food prices are excluded). That is one percentage point below the European Central Bank’s target of “below, but close to, 2%.”With the economy clearly operating below full capacity and unemployment above 12%, the risk of a further decline cannot be excluded, especially given downward pressure from a gradually appreciating exchange rate and a global context of negative growth surprises and subdued commodity prices. So it is past time to recognize the deflation danger facing Europe and to consider what more could be done to prevent it.

The first problem with deflation is that it tends to raise the real (inflation-adjusted) interest rate above its equilibrium level. As there is a zero lower bound to the nominal interest rate, the central bank may well find itself unable to drive the interest rate/inflation differential to a low enough level, which may result in a slump and even a downward spiral. True, some central banks (Sweden in 2009 and Denmark in 2012) have charged banks for taking deposits, thereby posting negative interest rates. But there are limits to such tactics, because if depositors are being charged, at some point it becomes preferable for them to buy safes and store banknotes.

This problem is highly relevant for the eurozone, which is emerging from a long recession, with GDP still below its 2007 level and the recovery, though real, still lacking momentum. Having recognized the danger, the ECB has lowered its benchmark interest rate twice in recent months, to 0.25%. The problem is that this may be too little too late to move the real interest rate to where it should be in order to foster sufficiently strong enough economic recovery.