Eurozone inflation hits its lowest levels for three years

Eurostat yesterday released its latest inflation statistics and the data for the eurozone provides some food for thought.

Inflation reached its lowest levels (1.1% on an annual basis) since February 2010. This might seem surprising on the surface given all the talk of a eurozone recovery and a turn around. Why hasn’t inflation followed? Well, generally inflation is a lagging indicator and therefore any recovery will take some time to feed through to prices and wages. However, as the graph below suggests, there is more at work here.

There has been significant disinflation (falling inflation but not negative inflation, which is deflation) in the eurozone and more importantly in the PIIGS. For all the talk of internal devaluation in the eurozone it has taken some time to feed through to the Consumer Price Index (CPI). Due to factors such as indirect tax increases and sticky prices and wages, it has taken some time for the impact to be fully felt – now that this is beginning to happen it is unlikely to stop immediately and could carry on for some time.

The data also shows that because of the effect described above, inflation in the PIIGS is diverging from the rest of the eurozone somewhat and particularly from the stronger countries in the north.

What does this mean for the ECB?

The FT has a couple of pieces today discussing this, calling on the ECB to do more to tackle the disinflation in the eurozone. While inflation is clearly well below the ECB’s target, the current nature of the inflation does present some issues for ECB policy.

• Firstly, there is the standard one size fits all conundrum – as inflation plummets in the PIIGS it remains stable in the north and threatens to increase as these countries post higher levels of growth. Adjusting the policies to suit these countries more could prompt unwanted outcomes in the stronger countries. Politically, it’s also worth remembers just how wary Germans are of inflation, as we highlighted recently. Finding the correct line between these two camps is incredibly tricky for the ECB.

• Secondly, while the struggling eurozone countries could use a boost in demand, the ECB may struggle to find the necessary targeted approach to do this. One measure which has been widely mooted is another long term refinancing operation (LTRO) to help boost liquidity in the market. However, as the graph above shows, there was no boost in inflation from the previous rounds, despite it totalling around €1 trillion. This is largely because the money did not filter through to the real economy and therefore did not impact consumer price inflation. Although things are improving there is still plenty of fragmentation in the market and loans to the real economy continue to fall in the PIIGS.

• This point also applies more generally in our view in terms of the tools at the ECB’s disposal. As we discussed at length here, although the ECB can do much to stop the break-up of the euro, it has fewer tools to help promote economic growth in the current circumstances, particularly in specific economies.

• In our view disinflation is not such a risk for many of these countries, in fact many need to see reductions in prices and wages to help boost their competitiveness, although it does of course have knock on impacts for their already flagging GDP growth. That said, deflation is a bigger risk because these countries have such large debt to GDP levels, which would only be exacerbated by deflation – although for countries such as Greece the need for further debt relief is already very apparent so the marginal impact of deflation is smaller.

All in all then, low inflation in the eurozone seems here to stay for some time due to the periphery pulling the average down, even if a fuller recovery eventually materialises. This will create some new issues for the ECB to deal with, however, given the divergence between countries it may well struggle to find the tools to have a big impact on this.

Stop me if you think you've heard this one before...

The Director of Open Europe Berlin, Prof. Dr. Michael Wohlgemuth, has dug up this old quote, which has a great deal of relevance for where we're at today. 

It's taken from the third Jean Monnet Lecture delivered in Florence by Ralf Dahrendorf - in 1979 (Dahrendorf was Member of the German Parliament, Parliamentary Secretary of State at the Foreign Office of Germany, European Commissioner for External Relations and Trade, European Commissioner for Research, Science and Education, Member and life peer of the British House of Lords, director of the London School of Economics, Warden of St Antony's College at the University of Oxford and Professor of Sociology at a number of universities in Germany and the United Kingdom...).

Pay attention:

"It is emphatically not the desire of some of the founding fathers to create another superpower; to have as much decentralization as possible and only as much centralization as necessary, is a prescription for a humane society to which many, including myself, would subscribe today."

He continues:

"The policy of the British government is to express its commitment to the Community – which is appreciated – to assure its partners that it does not propose to break the law – which is more than can be said of some others, though it remains to be seen what exactly the British Government has in mind – and to demand a « broad balance » of contributions and benefits. It will be for politicians to try and find out how much room for manoeuvre the notion of « broad balance » allows; at first sight, it certainly does not seem unreasonable. To say that we have to start again in order to build Europe would be wrong; there is much in the acquis communautaire which is worth preserving. But what we need is more than mere adjustments and reformlets; we need a fundamental reappraisal." 

 Then he absolutely hit the nail on the head:

"I have often been struck by the prevailing view in Community circles that the worst that can happen is any movement towards what is called a Europe à la carte. This is not only somewhat odd for someone who likes to make his own choices, but also illustrates that strange puritanism, not to say masochism which underlies much of Community action: Europe has to hurt in order to be good. Any measure that does not hurt at least some members of the European Community is (in this view) probably wrong. In any case it is regarded as unthinkable that one should ever allow those members of the Community who want to go along with certain policies to do so, and those who are not interested to stay out. The European interest (it is said) is either general or it does not exist." 

Full lecture here.

As they say, most things that are being said today, have been said better before...