Eurozone deflation risk was moderated in Q1 2021 by the higher headline and core inflation rates

The eurozone deflation risk is currently suggested to be tamed by the persistent acceleration of headline inflation and the unprecedented leap of core inflation since early 2021. The acceleration of eurozone Harmonized Index of Consumer Prices (HICP) from December 2020 to May 2021 was the fastest in the history of series, leaping from -0.3% to 2.0%.

According to the Deflation Vulnerability Index (DVI), eurozone’s deflation risk reached its peak in Q4 2020 due to past policy missteps, persistent low inflation expectations, and a series of adverse economic shocks, including the coronavirus disease 2019 (COVID-19) virus pandemic.

Why is the eurozone considered more vulnerable to the deflation risk?

Policy makers have the theoretical tools to avoid the onset of deflation if they act sufficiently and pre-emptively in practice. In Japan’s experience, monetary policy was insufficiently accommodative, although this was not widely appreciated at the time. This has some parallels with the eurozone’s experience.

The European Central Bank (ECB) only commenced its large-scale asset purchases from March 2015, more than six years after the onset of the global financial crisis and only following another severe adverse shock in the form of the eurozone crisis between 2011 to 2012. The ECB also opted to raise its policy rates despite escalating financial stress in both 2008 and 2011.

The consequence was persistent low levels of core Harmonized Index of Consumer Prices (HICP) inflation over a period of several years and persistent low inflation expectations, which eventually increased the vulnerability of Europe to the deflation risks. The die may already be cast, despite the ECB’s more emphatic and timely responses to the COVID-19 virus shock that heavily impacted the global economy.

An inflation targeting central bank needs to set a sufficiently high floor for underlying inflation, and deliver on this objective, to provide a sizeable buffer. The goal is to reduce the risk of inflation falling so close to zero that if the economy is then hit by a sudden, sharp drop in demand, it becomes susceptible to deflation. Policy makers in the eurozone did not do enough, early enough, to reduce this risk, with core inflation already well below the ECB’s “below but close to 2%” price stability aim prior to the COVID-19 virus shock.

The challenge of restoring lost competitiveness adds to the complexities of deflation in the eurozone’s context. Countries joining the single-currency area give up their ability to regain competitiveness via nominal exchange-rate adjustments. Therefore, they need to adjust through “real” devaluations: i.e., lower relative unit labour cost and price growth. However, if the most competitive economies in the eurozone (e.g., Germany) have low growth in unit labour costs and prices, this increases the risk that the less competitive economies will have to deflate.

Why is deflation such a concern to the eurozone and other parts of the world?

There are various problems associated with deflationary outcomes, including that the effective lower bound for nominal policy rates (around zero, or a little below zero) implies that real policy rates cannot be lowered sufficiently should deflation set in. This is especially constraining if, in a liquidity trap, for example, the economy’s equilibrium real interest rate turns out to be negative.

Another problem is high indebtedness. One way to reduce high debt-to-GDP ratios is to inflate them away, whereas deflation increases debt burdens in real terms. Eurozone member states have struggled to generate sufficiently high nominal growth rates to lower general government debt-to-GDP ratios both through the real growth channel (because of poor productivity and demographics) and via higher prices. Private-sector debt burdens are also high in many eurozone member states.

A related concern is that a mild deflation could turn into a more severe episode, with rising real debt burdens, widespread bankruptcies, and weak aggregate demand, all of which would increase the downward pressure on prices. In an environment of debt deflation, asset prices would come under renewed pressure and a credit crunch could follow, raising financing costs and again exacerbating the downturn and deflation.