During the past several months, the drop in Europe’s rate of inflation, a trend that economists call disinflation, has brought this indicator to nearly zero. As a result, deflation — a general reduction in price levels — has become a risk to closely monitor over coming quarters.
Although policy makers are understandably reluctant to discuss it publicly and contribute to market uncertainty, their statements hint that it is on their minds.
Inflation expectations move lower
Mario Draghi, President of the European Central Bank (ECB), has stated that he is focusing attention on the market’s inflation expectations. It's possible to measure these expectations in a couple of ways, such as by comparing the difference between yields on inflation-protected bonds relative to bonds without inflation protection or by analyzing the swaps market. As the rate of inflation fell earlier this year, the expectations metric revealed markets were pricing in severe disinflation. Since then, ECB policies — such as pushing the deposit rate to negative levels to discourage banks from holding reserves — and Draghi’s statements about the problem helped to push inflation expectations higher, but only briefly. Following the ECB meeting after the Fed’s Jackson Hole Symposium, the indicators initially ticked higher but then rolled over again — a discouraging signal.
Will deflation emerge despite central bank efforts?
Deflation is worrying because the world continues to be burdened by the debt overhang built up during the last credit cycle. Despite talk of deleveraging over the past several years, little debt has actually been retired. Instead, it has largely been moved around. The debt overhang may be one reason why credit creation in Europe continues to be weak. With so much debt still to deal with, there is reluctance to take on more. As an example, a recent long-term refinancing operation by the ECB, a periodic effort that supplies easy credit to banks with weak balance sheets, received a tepid response, reflecting lack of demand.
Should deflation emerge, it may pose a more difficult challenge today than in recent years because central banks have already used all of their policy tools in an attempt to fend it off. The Fed, the Bank of England, the Bank of Japan, and now the ECB have implemented a variety of quantitative easing measures and supplied massive liquidity to the markets. If these are not enough to prevent deflation, it is not clear what they might try next to reverse the trend.
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