The European Central Bank needs to start taking the risks of deflation more seriously. This danger should be top of its agenda when its governing council convenes for its monthly meeting this week.
The ECB’s line is that it does not see deflation on the horizon. True, the inflation rate has been below the target of close to but below 2 percent for over a year. The flash estimate for January was a mere 0.7 percent. But this still amounts to rising prices – not deflation’s actually falling prices.
True, too, that the ECB itself expects inflation to be below target for at least the next two years. But it doesn’t think the euro zone is close to repeating the experience of Japan which has suffered 20 years of flat prices.
Last month, Mario Draghi, the ECB’s president, gave four reasons why. First, the ECB had taken early decisive action. Second, the euro zone’s banking and corporate balance sheets are not in as bad shape as Japan’s were in the 1990s. Third, the ECB is moving ahead with a rigorous stress test to clean up bank balance sheets. Finally, inflationary expectations in the medium term – essentially the next five years – remain “firmly anchored” at the target level.
Each point needs qualification. First, although the ECB was moderately quick to cut interest rates, it has so far resisted engaging in quantitative easing – the most effective tool for combating deflation.