“Such policies (central bank policies to promote monetary inflation) are not cost-free. They encourage risk taking among investors searching for yield, potentially leading to malinvestment. They affect the distribution of income and wealth between the less affluent, who are most affected by low returns on bank deposits…

…and the wealthier, who tend to benefit most from rising share prices. Finally, perhaps most important, ultralow interest rates discourage savings for retirement and slow down the growth of existing pension assets. The ECB should incur these economic costs only if there’s a compelling reason to do so. Yet the current debate about deflation misses several key points, raising the prospect that the ECB could further distort the European economy to fight a “problem” that isn’t so problematic after all. Falling inflation rates in the eurozone are only partly explained by weak demand during the past two years. The ECB should consider other important, and presumably temporary, factors.”, Michael Heise, Chief Economist, Allianz SE, “The Upside of Europe’s Ebbing Inflation”, Wall Street Journal

Opinion

The Upside of Europe’s Ebbing Inflation

Declines in prices spurred by cheaper oil can help economies rebound.

By Michael Heise

The fall in the prices of oil and various other commodities is set to push eurozone inflation further toward zero in the coming months. This is creating enormous political pressure on the European Central Bank to act, including mounting calls for further quantitative easing that would include purchases of sovereign bonds. The ECB itself has contributed to the expectation that it can and will bring inflation back to its close-to-2% benchmark soon.

Such policies are not cost-free. They encourage risk taking among investors searching for yield, potentially leading to malinvestment. They affect the distribution of income and wealth between the less affluent, who are most affected by low returns on bank deposits, and the wealthier, who tend to benefit most from rising share prices. Finally, perhaps most important, ultralow interest rates discourage savings for retirement and slow down the growth of existing pension assets.

The ECB should incur these economic costs only if there’s a compelling reason to do so. Yet the current debate about deflation misses several key points, raising the prospect that the ECB could further distort the European economy to fight a “problem” that isn’t so problematic after all. Falling inflation rates in the eurozone are only partly explained by weak demand during the past two years. The ECB should consider other important, and presumably temporary, factors.

First, the fall in the prices of oil and other commodities since 2011 has directly translated into lower consumer-price inflation through lower prices for gasoline, other oil products, and food. Falling commodity prices also affect broader producer prices, as lower costs for energy and other inputs are passed through to sales prices in manufacturing and other sectors of the economy. In well-functioning markets, a prolonged downward trend in commodity prices, as we have seen, also lowers so-called core inflation, which excludes energy and unprocessed food.

Getty Images/Hemera

Second, those eurozone countries that went through excessive price and cost increases before 2009 are in the process of correcting them. Lower inflation or slight deflation in Greece, Ireland, Portugal and Spain are not a sign of damaging deflation. They are necessary to restore the purchasing power of people whose wages and incomes have declined and to improve these economies’ competitiveness on international markets. Once these countries recover, downward price pressures will disappear.

It is difficult to quantify the impact these two developments have had on inflation. But assume that commodity prices in 2014 stayed at their average 2013 levels and that inflation in the eurozone’s peripheral countries remained at 2%. The combined inflation impact of stable commodity prices and a lack of rebalancing in the periphery could easily be around 1%. In other words, inflation would today stand not at 0.4% but at 1.4%, far from the alleged dangers of deflation.

The ECB also shouldn’t be unduly concerned about low inflation expectations. Having declined somewhat in recent months, inflation expectations for the five-year horizon are currently somewhere between 0.7% (as indicated by bond prices) and 1.8% (as reported by surveys among forecasters). Inflation expectations among financial market participants do seem to be worryingly low. They are, however, also influenced by volatile oil and commodity prices. When oil prices drive down inflation, they also drive down inflationary expectations. There is a high correlation between actual inflation and inflationary expectations for the next two to five years. Inflationary expectations, in other words, are a dependent variable.

These facts have several implications for the ECB. One is that central bankers should better manage market expectations by making it clear that changes in monetary policy can take two to five years to feed through into inflation. The ECB’s tendency to overpromise has led to market demands that it deliver higher inflation faster, creating a needless challenge to the bank’s credibility.

Meanwhile, the ECB’s inflation target needs recalibrating. Because the ECB has promised inflation of nearly 2%, it faces growing calls to deliver. It would be better to return to the stability definition the ECB used before a strategy change in 2003, which was to define price stability as inflation “below 2%.” That would allow greater discretion in light of phenomena such as falling commodity prices. Central banks need room to maneuver in both directions. When commodity prices rose in 2011, eurozone inflation went up to 3%. The ECB, rightly, did not react by tightening significantly.

If the ECB reverted to its previous, broader definition of price stability under present circumstances, it might create additional uncertainty, and markets might worry about the ECB’s commitment to keep inflation above zero. But at least the ECB could be more explicit about which deviations from its close-to-2% target are worrisome and which are not only tolerable, but potentially positive for the economy. If oil and commodity prices continued to fall in 2015, the result could be an inflation rate below 0.5%. This would be no failure of the ECB but rather would help the recovery. It is the ECB’s job to explain this. Otherwise, analysts and investors will continue to demand that it counteract falling commodity prices by launching a quantitative easing program.

Mr. Heise is chief economist of Allianz SE in Munich.

Posted on December 3, 2014, in Postings. Bookmark the permalink. Leave a comment.

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