By the Blouin News Business staff

Draghi eyes the dragon of deflation

by in Europe.

ECB President Mario Draghi

ECB President Mario Draghi. Photo Credit: Reuters/Ralph Orlowski

The European Central Bank’s decision to cut interest rates rather than wait to see how sturdy are the shoots of recovery was a surprise. The move underlines the fragility of the recovery in the euro zone, and the central bank’s fear of falling inflation turning into deflation. ECB head Mario Draghi has also dusted off his “whatever it takes” line from 2012, saying the bank stands ready to cut rates further — which, with its new lending rate at a record low 0.25%, would mean to at least zero — and to keep pumping liquidity into the banking system well into 2014.

Inflation in the euro zone has been falling since the middle of the year, though the 0.7% figure for October was much lower than expected. In the troubled southern periphery inflation has been particularly low, just as unemployment has been stubbornly high. The ECB is targeting just under 2% inflation across the euro zone, a rate not seen since the start of this year.

There has been substantial political opposition from Germany to the ECB providing continued stimulus — Bundesbank president Jens Weidmann voted against the latest rate cut — but it is difficult to gainsay the argument that the euro zone has fallen into a dangerous grey zone of disinflation where consumers and businesses are wavering over whether to spend their cash. They need to be encouraged to do so. For if they don’t, because they suspect prices will be lower tomorrow than today, deflation will become a self-fulfilling prophecy. It would be over-egging the pudding to say that Europe is at risk of repeating Japan’s deflationary decade and a half, but Draghi himself acknowledges that the eurozone is at risk of a “not short” period of low inflation.

Injecting growth back into the economy will require more than just ultra-cheap money. Commercial banks have to be willing to lend and companies and individuals to borrow. Dealing with the former lies more in the ECB’s remit than the latter. One option would be to charge commercial banks for parking their money with the central bank: such a move might encourage more lending to those who can put the money to productive work in the real economy. Credit to the corporate sector is declining at an annual rate of 5% in the euro zone. Spanish and Italian banks have been particularly bad in this regard, preferring to sink the cheap money the ECB is supplying into government bonds.

The biggest potential boost to regenerating demand in the euro zone lies not with its supranational monetary policymaker but in the gift of its largest national economy. Germany could relax its fiscal policies to lower its current account surplus. That should help boost demand in the real economy and circumvent any blockages in the transmission of monetary policy through the financial system. It would, however, require Germany to let go of its national obsession with keeping inflation in check. Yet as Draghi has now indicated, there are risks to Europe’s economic recovery from deflation, too.