Last Thursday, Eurostat launched its report concerning inflation in the Eurozone for the month of March. It was estimated at – 0.1%. This result is problematic because the European Union’s Bank (ECB) status decrees it has to flirt with 2% per year. Inflation has always fluctuated around this value between 2010 and 2013. It’s only since 2014 that it began its move on the downside, moving around 0.3%. Persistent negative inflation rate is a quite new phenomenon. It has been seen for the first time between December 2014 and February 2015. It seems that February is a cursed month for inflation; again in 2016, it was about -0.2%. Rising at -0.1% is encouraging, but far from the 2% target.

Why is inflation so important?

Inflation is described as an increase in the general price level of goods and services. As those increase, the value of money decreases because with a given amount you can buy less. In other words, it’s a ratio of price per quantity through time.

Inflation has several sources. It can come be related with money supply, but it’s not the case in the European Union. Other theories admit it comes from a decrease in aggregate supply of goods and services, which is called “cost push inflation”; or from an increase in aggregate demand of goods and services, or “demand pull inflation”. Concerning the first, we suppose that companies are maximising productivity and minimising costs. With an increase in production costs, firms have no other possibility than pass the costs to consumers, so they will higher their prices in order to maintain profits and margins with the same amount of goods. When we talk about increasing costs, it includes taxes, wages or raw materials.

The second source of inflation, the demand pull inflation, appears when households, businesses, governments or foreign buyers want to purchase more output than the economy can produce. Due to the limited resources of economy, global demand generates an increase in prices, which creates inflation. This is why inflation can be considered as well as a competitiveness indicator, or a growth indicator.

But how is inflation calculated for all the goods and services we consume?

The “basket of goods” method is used. It consists in grouping each goods in 4 “Boxes”, and then estimate the percentage of price evolution for each. The first one is food, alcohol and tobacco, then comes the energy goods, thirdly the non-energy industrial goods, and finally services. Eurostat then estimates the weight of consumption of these basket of goods in the global economy. By then, it calculates a weighted mean of the price evolution for all baskets. For example, in the Eurostat report published on March 31, the -0.1% inflation in March 2016 is obtained by: (195.3 * 0.7 + 97.4 * – 8.7 + 0.5 * 265.5 + 441.8 * 1.3) /1000.

Inflation UE image

The interesting point about the basket method is that inflation depends of imports and exports, which means: estimating inflation for a country can be influenced by foreign events. And it’s what happened actually here. The European Union is largely dependent on energy imports. Even though the weight of energy is relatively small, OPEC’s oil prices are drilling down European Union’s inflation. Confronted to that fall, the three other sectors can hardly maintain it. Couple that with the fact that, if we subtract oil imports, inflation is about 0.93 which is much more sustainable.

Why is deflation a problem?

Intuitively, we could think that because deflation is a global decrease in prices, it should boost consumption, which should increase firms’ profits, hiring more workforce, or increasing wages, which would another time increase expenditures. And it’s true, short term inflation isn’t a problem. The danger of deflation is when it persists on several periods. By then, it can have several bad consequences. The problem comes from the expectations of consumers and firms. Concerning the consumers, they might reduce their demand for goods, since they expect lower prices to come. Due to the decreasing demand, firms will lower their prices. Furthermore, unemployment rises and wages decline because firms struggle to make profits. Having that said, consumers do not only expect to earn less, but also do they know that the more indebted they are, the worse their condition will be because their salary will decline while the loan payments will stay the same. This is what leads them to keep their savings rather than expend them. Consequently, deflation leads to an economic slowdown in the mid/long term.

So how can the ECB fight deflation?

The money creation process

The central bank’s standard policy to manage economical fluctuation is done via the central bank interest rates. It allows central banks to control the quantity of liquid assets in the financial circuit. In a simplified manner, a commercial bank which needs cash will come to the central bank and exchange the central bank money she owns against cash. But this exchange is submitted to an interest rate. The higher the exchange rate is, the less profitable it is for a commercial bank to get liquid assets. So if a central bank wants to stimulate the economy, it will lower its interest rates in order to ease commercial banks to have cash. If commercial banks can easily get cash, they will lend easier which allows more investments, etc… and as we have seen, global growth is supposed to bring inflation.

Since 2008 crisis, ECB has been very accommodative, keeping its interest rates close to zero. It has also applied extraordinary measures, like quantitative easing, to facilitate commercial banks to lend. Quantitative easing operations consist in buying financial assets on capital markets in exchange of newly created money. After 2008 crisis, lots of European banks had “junk” assets. Buying those in exchange of liquid assets allowed them to reduce their risk and at the same time get cash. It’s difficult to find any better solution.

However, it didn’t seem enough to boost economic growth. So since June 11th 2014, ECB started to apply a negative interest rate.

The negative interest rate danger

Almost all economic theories are based on the “zero lower bound” assumption, which means that the central bank’s interest rate is above or equal to zero, and it can’t cross this limit. Going below this benchmark means commercial banks are paid for borrowing cash to the central bank. Conversely, depositors have to pay interest for the money they deposit. With such policy, banks are not recommended to lend money, they are obligated. Another consequence of negative interest rates is to prevent currency of rising too much. Indeed, it discourages investors from holding local currency as refuge currency, because of its negative yield. So local currency will depreciate. This might raise the price of imports, but for foreigners it will reduce the price of exports. Combining these two consequences: aggregate demand increases, which might create a demand-pull effect.

Unfortunately, not all effects of negative interest rates are positive.

The first unintended consequence is the effect of hoarding physical cash. It is demonstrable that in the situation of negative interest rates, it is more profitable to keep cash physically then deposit it at the bank. Indeed, the yield of money is bigger than investing it. This tends to increase the deflationary pressure, by stopping consumption and investment. On the other hand, negative interest rates might create waves of panic, with people withdrawing large amounts of cash from banks in a very short period. Such aftermath can destabilize bank runs.

It is also possible that going below the zero lower bound contributes to asset bubbles. Thus, borrowers are in a certain way paid to go into debt. Compared to the situation when rates were positive, there is no more constraint to indebt yourself. If people can receive money by borrowing, it may cause a rush of borrowers, which is precursory to a crisis.

Finally, it is important to talk about the currency wars. ECB isn’t the first bank to cut its rate below zero and to encourage its currency to weaken. Switzerland, Japan and Sweden are doing the same. Japan has the same purpose as ECB, while Switzerland and Sweden have the aim to reduce the attractiveness of their currencies considered like safe assets. Yet, if a currency falls, another must rise. Two central banks applying negative rates at the same time will compete to have the lowest one. Engaging such clash might reduce the aim of stimulus measure towards the country which applies the same policy.

What’s next?

Now the big question is: will negative rates policy work? Combined with Quantitative easing operations, these extraordinary measures should encourage commercial banks to lend more. But we will only have answers in the low run.


Macroéconomie II, Professeur Saint-Amour

BBC news


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