Another month, another downside surprise on euro zone inflation

July 31, 2014

sale signsNobody except a born pessimist ever expects a bad situation to get incrementally worse.

But the relentless downward trajectory of inflation in the euro zone has got plenty of economists sounding unconvinced that the situation will turn around any time soon.

A surprise plunge in Spanish inflation to -0.3 percent in July and a lack of any additional inflation pressure from Germany, the euro zone’s largest economy, dashed hopes that euro zone inflation would rise from 0.5 percent back toward the European Central Bank’s 2.0 percent target.

But the unexpected fall to 0.4 percent, the lowest since the dark days of the financial crisis in 2009, underscores how powerless the ECB is to address the situation in the short-term – and how dangerous it is to allow the current situation to continue.

When the Bundesbank, famous for its inflation-fighting credentials, calls for higher pay deals in Germany, you know there is a problem.

Indeed, the main problem is that interest rates are as low as they can go.

No amount of cash injections into the financial system – whether the planned long-term refinancing auctions for September and December, or any consideration of outright bond purchases or quantitative easing – can take place before the ECB completes its health check on euro zone bank balance sheets.

And with fiscal austerity endorsed by the ECB still in place across the euro zone and the real threat of repercussions from EU sanctions on Russia, the economy, while growing, is looking vulnerable.

Lena Komileva at G+ Economics wrote:

Looking beyond the monthly noise of the figures, the 3- 6- and 12-month trends remain negative. This offers little optimism about the effects of ECB policy stimulus on real economies via financial transmission channels such as a weaker euro, higher equities or the notable financial (windfall) created by record low peripheral bond yields. 

Sure, core inflation, which strips out a raft of volatile components, was steady at 0.8 percent. The fall in inflation this month was down to energy prices. And services inflation was steady at 1.3 percent. But core goods inflation was zero. The ECB does not target any of these measures.

Jonathan Loynes at Capital Economics wrote:

…  it is clear that underlying price pressures are very weak indeed. And with aggregate euro-zone inflation set to remain low, the peripheral countries’ debt reduction efforts will continue to be hampered by flat or falling prices.

Inflation may soon rise, although some forecasters already say it will fall to 0.3 percent in August before it does.

Either way, it underscores just how far apart the euro zone is from the U.S., where the Federal Reserve on Wednesday sounded much more optimistic that the risk of deflation has passed.

The Fed already is eyeing a rate rise, although not likely until the middle of next year. The ECB — certainly the Bundesbank — no doubt wishes it had it so good.

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