ECB deflation risk denial has echoes of 2009

January 31, 2014

Euro zone policymakers like to talk. They often contradict each other at separate speaking engagements on the same day. But they have struck a chorus in recent weeks, asserting that deflation is not a threat.

Members of the ECB Governing Council have been particularly vocal, insisting they will not have to alter policy to counter falling prices.

Jan 9: Mario Draghi says the euro zone may “experience a prolonged period of low inflation” — steering clear of even mentioning the word deflation.

Jan 21: ECB’s Ewald Nowotny says “we neither see inflation nor do we see deflation in the euro zone”.

Jan 23: Draghi says “the risks of deflation or inflation are limited at this point in time.”

Jan 28: ECB’s Jens Weidmann says “the outlook for inflation, but also for the risks of deflation let us look positively into the future”.

Compare those words with IMF chief Christine Lagarde, who warned this month:

With inflation running below many central banks’ targets, we see rising risks of deflation, which could prove disastrous for the recovery.

If inflation is the genie, then deflation is the ogre that must be fought decisively.

Euro zone inflation fell to just 0.7 percent in January, according to preliminary estimates published on Friday, and has been below the ECB’s 2.0 percent ceiling now for almost a year.

It’s not there yet, but it’s a very short distance from weak rises to outright falls in prices on a year ago.


Indeed, in several parts of the euro zone, most notably in Greece, that shift has already taken place and shows no signs of turning around. Even in Europe’s biggest economy, Germany, the consumer price index fell 0.7 percent in January, taking the annual increase down to 1.2 percent.

The worry of course is that the ECB has been here before.

Inflation turned negative for five consecutive months in 2009. Then, President Jean-Claude Trichet sounded just as adamant as Draghi that he had no problem on his hands.

Deflation, the scourge of the Japanese economy for a generation, is extremely dangerous as an economic force. Once it has taken hold, it churns a vicious cycle of cautious spending and decreasing demand, which in turn pushes prices lower.

The trouble is, unlike the generally-accepted textbook definition of a recession, two consecutive quarters of contraction in gross domestic product, there is no length of time prices have to fall to be officially called deflation.

So the interpretation, and its use, is often suitably ambiguous.

Below is what policymakers during Jean-Claude Trichet’s regime said in 2009 and how inflation in the euro zone turned out:

April 27: ECB’s Ewald Nowotny says does not see deflation

May 29: Prices stop rising year-on-year for the first time

June 16: ECB’s Ivan Sramko says deflation risks low

June 24: ECB’s Bini Smaghi sees no deflation

June 30: Prices drop 0.1 percent, negative for the first time

July 1: President Jean-Claude Trichet downplays deflation risks

July 6: ECB’s Yves Mersch says deflation risk has decreased

Prices continued to fall on a year-ago basis from June until November 2009.

Then, inflation started picking up, providing relief for the ECB which had little space to cut the refinancing rate below the 1.0 percent low it was already at.

But now it is jammed into an even tighter corner, with the benchmark rate at just 0.25 percent and some economists in the latest Reuters poll expecting Japanese-style cuts in the coming months.

It may be true that the euro zone is further away from deflation now than it was in 2009, not long after a historic crash in stock markets around the globe.

But waiting for deflation to set in while hoping for a different outcome could derail an already very fragile economic recovery.

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