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The ECB is projecting that inflation in the Eurozone will remain below 2% until at least 2017. Very low inflation may sound like a good thing but it creates significant challenges for central banks. It is also a particular problem for the Eurozone as it is a threat to the rebalancing process.

During last week’s European Central Bank (ECB) press conference, President Draghi described the Eurozone as an “island of stability”. After the experiences of the last five years this may be a bit of a stretch. However, with inflation well below target for over a year now and projected by the ECB to remain below 2% until at least 2017, the Eurozone can aptly be described as the “island of price stability”. If the ECB projections are accurate, it will be the longest period of time since the euro was created that inflation has been away from its target.

Very low inflation may sound like a good thing, but one of the risks of prolonged low inflation is that it could become entrenched in inflation expectations and people’s behaviour, thereby becoming the new norm. President Draghi knows this, but feels that as long as long-term inflation expectations remain stable, there is little to worry about. According to the market there are no signs of alarm yet that the ECB should worry about: the 10 year inflation swap has fallen slightly but the 5 year-5 year inflation forward (what the market is pricing in for inflation for the second half of the next decade) remains steady and broadly consistent with the ECB’s “close to but below 2%” inflation mandate (see chart 1). On the other hand, shorter-term inflation expectations have come down significantly and are at their lowest level since the financial crisis. But these do not seem to be of as much interest to the ECB.

Focusing only on long-term inflation expectations can be a dangerous game for a central bank to play. Firstly, stable long-term inflation expectations might not be sufficient to avoid future deflation. Today’s long term eventually becomes tomorrow’s short term. As the IMF recently noted, long-term inflation expectations in Japan were resiliently positive even after the country had fallen into deflation. A short spell of deflation does not convince everyone that it is permanent (as we saw correctly in the US in 2009), so long-term inflation expectations are likely to be the last indicator that deflation is here to stay, not the first.

Secondly, the surprising stickiness in long-term inflation expectations, while short-term inflation expectations are falling, could be related to central bank credibility. It may be that the market is not worrying about deflation in the long term because it believes that the ECB would act in the event of deflation, for example with quantitative easing (QE) or other drastic measures. Paradoxically, stable long-term inflation expectations may prevent the ECB from engaging in exactly the kind of policy that would prevent deflation. Eventually something would have to give.
 

Chart 1: Looking forward or forward looking

Source: Bloomberg Finance LP

A third risk of looking solely at long-term inflation expectations is that firms’ selling price expectations and wage negotiations  in the Eurozone are highly correlated with shorter-term measures of inflation expectations (see chart 2). So while the central bank is happily focused on the long-term horizon, very low short-term inflation expectations could become entrenched in pricing behaviour and wage-setting such that they become more permanent. Low wage increases mean lower aggregate demand which means lower inflation. The new low inflation environment would only later be priced into long-term expectations. At this point, the ECB would have to act much more aggressively than would have been required had it acted earlier.

Chart 2: Wages and prices now, not tomorrow

Source: Bloomberg Finance LP, Eurostat, European Commission Survey of Services

Indebted island

So persistent low inflation is not something a central bank should cheer about, but the threat posed for the Eurozone is particularly severe. As recently pointed out by the IMF, very low inflation can be very problematic for highly indebted countries and can be an obstacle to the ongoing deleveraging for the private sector. High inflation is effectively a transfer from borrowers to lenders because it reduces the value of the money that was loaned (you can no longer buy as much with it). Conversely, low inflation increases the burden of the debt. Another way of thinking about it is that high inflation reduces the real interest rate paid, while low inflation decreases it. Why else do countries in fiscal difficulties so often resort to money printing and hyperinflation?

Low inflation may be an even bigger threat to the rebalancing process within the Eurozone. The easiest way for the periphery to regain competitiveness relative to Germany and the core is for the periphery to have inflation at, for example, 1% and the core to have inflation at 3%. This would improve competitiveness at 2% a year, keep overall inflation close to target and prevent outright deflation in the periphery. However, if inflation remains below target in the core, the periphery will need outright deflation to gain any significant competitiveness. But deflation in the periphery would make those countries' burden of debt even harder to deal with. Without inflation in the core it is almost impossible for the periphery to both gain competitiveness and successfully deleverage.

Even if low inflation fails to become entrenched in inflation expectations, it can be a problem. If wages continue to rise at a similar nominal rate, lower inflation means that wages are higher in real terms. While this is clearly good for consumption, it also means higher real input costs for firms which can negatively affect the firms’ employment intentions. In other words, if inflation is on a downward trajectory but people do not take this into account, there could be an impact on employment. With the unemployment rate in the Eurozone still historically high and spare capacity still very large, weaker employment is the last thing that is needed.

Yet another challenge low inflation poses for any central bank is that it can limit the effectiveness of monetary policy. Real interest rates matter more than nominal interest rates, so high inflation actually makes monetary policy looser by further reducing the real cost of borrowing. But low inflation will make any given level of policy interest rates less effective. With ECB rates already close to zero, low inflation can become self-reinforcing through low growth unless the ECB is willing to engage in more drastic action like QE. An unwillingness to do so creates the danger that the island of price stability could ultimately translate into a far less welcome "island of GDP stability" – a no growth zone.

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