Draghi is playing with fire on deflation risk
By Pierre BrianĂ§on
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.
Mario Draghi is playing with fire. The European Central Bank accepts that the euro zone has entered a long period of low inflation â but its president sees no need to act on it. If Draghi keeps hesitating, he risks the institutionâs credibility, squandering the gains of his 2012 promise to do âeverything it takesâ to preserve the euro.
According to the ECB party line, the euro zoneâs inflation rate (0.8 percent according to the latest numbers), is low enough to be disruptive if it persists. But there is no current danger of deflation, since consumers and businesses expect a 2 percent rate over the five-year term.
That complacency is misplaced, because it is based on the euro zone average. Some euro member countries are already close to the deflation danger zone. In any case, the ECB is in breach of its longstanding and self-imposed mandate to keep inflation âbelow but closeâ to 2 percent. According to its own forecast, a weak recovery will keep the inflation rate at 1.1 percent this year and 1.3 percent in 2015.
Deflation is the expectation of a permanent decrease of the price index, so Draghi may seem to be right. Inflation is low but still positive. Nominal hourly labour costs were up 1 percent last year, leaving wages roughly stable in real terms. For now, the monetary union isnât in danger of replicating Japanâs years of small price and wage declines.
The stability is partly due, by the way, to the labour market ârigiditiesâ pilloried by the Frankfurt-to-Brussels consensus on the need for so-called âstructuralâ reforms. Had nominal wages been as flexible as the austerity brigade advocates, deflation would already have struck.
Mario Draghi may take comfort in the current inflation expectations, but he must know that the science of measuring them is uncertain at best. Of more immediate concern is the possibility that deflation could occur in just a few member countries.
According to the latest available numbers, prices are roughly stable year-on-year in Spain, Portugal and Ireland and barely moving in Italy and France. They are falling sharply in Greece (minus 2.9 percent year-on-year), more slowly in Cyprus (minus 0.8 percent). Near-zero inflation coupled with negative growth rates â as seen last year in Greece, Cyprus, Spain, Italy, Portugal, Slovenia and the Netherlands â means that real interest rates remain positive, increasing the burden of debts.
Should any of these countries be caught in the deflation spiral, the ECB will find it is too late to react. For while central bankers know how to fight inflation â with higher interest rates – they donât know how to fight deflation once it has taken hold, especially when policy interest rates are almost zero.
Granted, the ECB has a specific problem: the segmentation of the euro zoneâs money and credit markets. In theory, it could try to aim monetary policies at the weakest economies of the euro zone. In practice, the policies face strong German opposition.
The Bundesbank never misses an opportunity to trumpet the risks of higher inflation and low interest rates, while screaming newspaper headlines accuse Draghi-the-Italian of leading German savers to ruin. Accommodation for the South meets reprobation in the North.
The ECB president told German magazine Der Spiegel a few days ago that he saw âno need for immediate actionâ on the deflation front. This week he is likely to insist yet again on the central bankâs effort to ârepair the monetary transmission mechanismâ â with low interest rates and the launch of the banking union.
But his is a dangerous game. The damage from waiting could be irreparable. How long can he afford to delay policies specifically designed to produce asymmetrical effects â such as a targeted liquidity boost that would ensure that ECB money flows down to the businesses that need it most? At some point he will have to deal with the German challenge head on. Better now than later.