A year ago, the European Central Bank took advantage of a temporary uptick in prices to declare victory in its fight to bring eurozone inflation up to its target of “below, but close to, 2 per cent.” But the triumph proved short-lived. Headline inflation has since come down again, and core inflation, which strips out volatile energy prices, is back to about 1 per cent. Yet this should not be a major concern for the ECB.
The ECB’s staff projections still see eurozone inflation reaching close to 2 per cent by 2021-2022. But, having wrongly predicted a pickup in inflation for the past several years, these forecasts now have little credibility. This is apparent in financial-market expectations of eurozone inflation as measured by so-called inflation swap rates, which are stuck below 1 per cent even five years into the future. And markets predict that euro-area inflation will still be below 1.5 per cent a decade from now.
This puts the ECB in a quandary. The eurozone economy is weakening, which might further diminish inflationary pressures. But the ECB does not dare to restart its sovereign bond-buying programme with the aim of providing additional economic stimulus, because national central banks in the eurozone already hold large amounts of their own governments’ bonds. Making these central banks buy even more would put them in a very difficult position if any government were to experience financial stress. This is why the ECB has so far limited itself to announcing that it will continue to provide commercial banks with longer-term, three-year financing at ultra-low rates.
The ECB is not alone in facing unexpectedly low inflation. The Bank of Japan launched an even larger bond-buying programme and capped interest rates at zero, and yet inflation remains minimal. And although inflation in the United States is much closer to 2 per cent, it is still far lower than expected.
Central banks in advanced economies fear that this lack of inflation could quickly turn into falling prices, and that any slide into such outright deflation would be catastrophic. But are these worries justified?
Those fearing deflation point to the Great Depression of the 1930s, when unemployment rose to about 25 per cent in the US and some Western European countries, and widespread economic hardship fostered political extremism. But one cannot really compare recent mild bouts of deflation, such as prices falling by 1 per cent per year in Japan, to the situation in the 1930s, when prices fell by 20 per cent-30 per cent. As a deflationary event, the Great Depression remains unique.
Nonetheless, some argue that even mild deflation could cause unemployment, because reducing nominal wages is generally difficult. On this conventional view, falling prices would lead to excessively high real wages, resulting in job losses.
But recent experience shows that most advanced economies have maintained high employment despite inflation being close to zero. The obvious example is Japan, which currently has record-high employment and a low unemployment rate — undermining the standard narrative that the country is “mired” or “stuck” in a low-inflation trap. And although the Japanese economy has grown very little in recent decades, this is mainly due to a shrinking working-age population. In terms of per capita growth, Japan has not done significantly worse than Europe or the US.
Smaller European economies such as Switzerland and Sweden show a similar pattern of low inflation and high employment. More significantly, the much larger eurozone has also been moving in this direction for some time.
Despite low eurozone inflation, the labour-force participation rate has steadily increased. Today, the eurozone has a higher proportion of economically active adults than the US. Employment is at a record high, and unemployment continues to fall, although it remains high in some southern European countries.
Overall, the eurozone economy has not performed as badly as the consistently gloomy headlines would suggest. Some countries are still struggling to recover from the euro crisis at the beginning of this decade, but others are doing much better. And although average per capita GDP growth across the eurozone has slowed over the past 20 years, this deceleration is no worse than in the US or other developed economies.
The fact that eurozone inflation is closer to 1 per cent than 2 per cent is not ideal, but this is a minor inconvenience that most people do not even notice, and which has not impeded a continuous decline in unemployment. The ECB does not need to pull out all the stops and invent ever more instruments in the forlorn hope of increasing inflation by a few tenths of a percentage point. The message for Europe’s nervous central bankers is clear: Don’t worry, be happy.
The writer is Director of the Center for European Policy Studies. © 2019 Project Syndicate