Deflating euro zone inflation expectations

July 1, 2014

EThe euro zone is not deflating, it’s just at risk of a too-prolonged period of low inflation, says European Central Bank President Mario Draghi.

Judging by recent evidence, it might be very prolonged, which is bad news for an economy struggling to shift out of low gear.

Inflation held steady at just 0.5 percent in June, well below the ECB’s 2.0 percent ceiling, stuck in what it calls the “danger zone” of below 1.0 percent for nine straight months.

And the latest from the euro zone’s private sector also shows companies are nowhere close to regaining any pricing power.

Several prominent forecasters now say inflation will fall even lower than where it is now.

The ECB’s staff project inflation at 0.7 percent for this year, which may already may be too optimistic.

Euro zone inflationJust months ago, almost every private sector economist polled by Reuters echoed the central bank’s assessment that inflation would not revisit a cycle low of 0.5 percent in March.

Before that March figure came out, they were convinced inflation wouldn’t revisit the low of 0.7 percent in October.

Now that inflation has been stuck at 0.5 percent for two months in a row, some are rightly saying 0.7 percent may look too high for the year as whole, unless there is a strong snap-back.

But the euro zone aggregate figure hides what’s going on in member states.

In June, three euro zone countries reported outright annual declines in prices: Greece, Portugal and Cyprus.

Taken together with signs the fragile euro zone recovery may already be faltering, the threat of deflation remains real.


The danger of course, as the Bank of Japan knows well, is that when deflation sets in, it does so very gently.

But once it does, it can take a generation to escape.

Barclays economists say that euro zone inflation will remain around where it is until the end of the year, averaging 0.5 percent, with a dip to 0.4 percent over the summer.

They only expect a small increase to average 0.8 percent in 2015.

Citi reckons that most forecasters, presumably also those at the ECB, have underestimated downward effects from past falls in energy and food prices.

The main driver behind the recent downward trend in headline inflation has been the pass-through of previous declines in energy and food commodity prices, which probably have been largely underestimated by consensus. We reckon both factors have not yet completed their disinflationary impact on the headline rate.

Together with favourable base effects, this implies that the non-core food and energy items are likely to continue driving the headline inflation rate lower at least until August, in our view. We expect euro area HICP to decline further to around 0.3 percent during the summer.

Nomura cut their forecast for 2014 euro zone inflation to 0.6 percent, from 0.8 percent last month.

Jennifer McKeown at Capital Economics sums it up:

June’s weak euro zone inflation figure will add to pressure on the ECB to provide more policy support, particularly given recent signs that the recovery may already be slowing.

With unemployment still near a record high and plenty of slack remaining in the economy, any rise in inflation is likely to be very modest.

Mario Draghi cut interest rates to record lows last month and announced another series of hundreds of billions of euros worth of long-term loans to boost lending to businesses. That was done in the hope that will eventually bring inflation back to target, which is the ECB’s sole mandate.

But a majority of euro money market traders and economists polled over the past month do not expect that cheap cash to boost lending in the region.

Instead they expect some, if not all of it, to end up in already-inflated financial assets.

But some economists do expect inflation to rise, particularly given possible shocks that could send energy prices spiraling higher.

(The ECB has dealt with high energy prices before, using very similar rhetoric to what it is using now to explain away inflation persisting well above target, not below.)

Stephen Lewis, chief economist at Monument Securities, wrote:

The relatively late date of Easter this year has added to the difficulties in interpreting euro zone inflation data because there is always substantial month-to-month variation in consumer prices, related to the holidays.

At the same time, the euro reached its peak against the U.S. dollar in early May and has been edging lower since then. At the very least, it seems likely that disinflation will appear less marked in the euro zone over the remainder of this year than it has so far.

Either way, it looks like Draghi may have more policy work to do. Just not this week.

— with reporting by Rahul Karunakar, Swati Chaturvedi and Siddharth Iyer

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