The European Central Bank’s Inflation Conundrum

November 6, 2013

By JACK EWING

The New York T imes

FRANKFURT — The European Central Bank will meet on Thursday under renewed pressure to do more to stimulate the Continent’s sluggish economies, as evidence grows that the recovery is failing to pick up speed and that inflation has fallen so low as to become worrisome.

Mario Draghi, the president of the central bank, has already used a mix of threats, promises and cheap money to avoid a euro zone breakup and to help the most financially troubled governments get access to the borrowing they need. Now a growing chorus is hoping the central bank will signal a willingness to step in again.

This time, those advocating action want the central bank to use its power over the euro currency to drive up inflation, which is at such low levels that some economists believe it signals the possibility of deflation, or a decline in prices and wages that can become a vicious circle of economic atrophy. It is a challenge that perplexed Japan for years and that deeply concerned policy makers at the Federal Reserve in the United States during the early stages of the financial crisis.

But talk of deflation is an issue that deeply divides economists, some of whom see the threat as overblown and others who fear that the central bank is not taking it seriously enough. Those who are worried point to an unexpectedly sharp drop in inflation last month as a warning of abysmally weak demand and a sign that the euro zone could be headed for years of stagnation or even depression.

Those who are more optimistic see low inflation as a sign of stability and evidence that Europe’s troubled southern periphery countries, like Spain and Greece, are regaining their ability to compete on price in world markets.

Mr. Draghi has given little public indication of whether the European Central Bank will make a move on Thursday. But many economists and analysts predict that the central bank, not wanting to appear panicky, will wait a month until there is more data, then act in December.

In any case, the closed debate among the bank’s 23-member Governing Council on Thursday is likely to be contentious, judging from the range of views among professional economists, political leaders and business managers.

Some economists, like Simon Tilford, deputy director of the Center for European Reform in London, argue that the euro zone is already stuck in the same kind of economic quicksand that trapped Japan for decades, and that the European Central Bank must aggressively stimulate growth now, not only by cutting rates but also by taking steps to pump money into the economy.

“There is a point where the euro zone will pass the point of no return,” Mr. Tilford said. “Policy needs to be focused single-mindedly on reflating the economy.”

Others, like Jörg Krämer, chief economist at Commerzbank in Frankfurt, call such doomsaying “ridiculous.” The lower rate of inflation is a sign that wages have fallen in the euro zone’s southern tier, where they were too high in relation to worker productivity, he and others argue.

“What we see is a positive thing,” Mr. Krämer said. “Peripheral countries have regained price competitiveness. This is a wanted correction. This has nothing to do with deflation.”

For the European Central Bank, it is a tough call. Economic indicators have been ambiguous and subject to wildly varying interpretation. Only a couple of weeks ago, news that Spain had returned to growth for the first time in two years raised hopes that the euro zone was on the verge of a turnaround after five years of recession or very slow growth.

But then came data showing how far the region still has to go. Unemployment in the euro zone remains stuck above 12 percent, and on Tuesday official forecasts by the European Commission portrayed an economy struggling to gain momentum and still vulnerable to shocks.

One jolt could come from currency markets. The euro has fallen in recent days against the dollar, but it remains at high levels not seen since February. At about 1.35 euros to the dollar on Wednesday, the common currency was close to a value that could threaten a rebound in exports by countries like Spain. A stronger euro makes European products more expensive when purchased with other currencies.

“There is a risk that it just makes recovery even slower than it has already been,” said Ulf Mark Schneider, chief executive of Fresenius, a German health care company.

On Tuesday, Fresenius, which has major operations in the United States, said that operating profit fell 1 percent in the first nine months of the year to 2.2. billion euros. Profit would have grown 1 percent were it not for currency fluctuations, the company said.

Paradoxically, the rise in the euro is partly a byproduct of stronger exports from the most troubled countries. They have improved their competitiveness and now have trade surpluses instead of deficits. Spain and Greece helped the euro area trade surplus rise to 7.1 billion euros, or $9.6 billion, in August. That compared favorably to a surplus of 4.6 billion euros in August 2012. A trade surplus tends to push up the value of the currency.

A very large trade surplus is considered unhealthy, though, because it is achieved at the expense of other countries and can be a symptom of weak domestic demand.

Last week the United States Treasury Department, in a report to Congress, criticized Germany for a trade surplus that has become bigger than China’s. The German surplus raises the risk of deflation, the Treasury Department said, in a statement that caused an uproar in Berlin.

“Germany’s anemic pace of domestic demand growth and dependence on exports have hampered rebalancing at a time when many other euro area countries have been under severe pressure to curb demand and compress imports in order to promote adjustment,” the Treasury Department said. “The net result has been a deflationary bias for the euro area, as well as for the world economy.”

While lower prices might seem like a good thing for consumers, in fact deflation is pernicious. It is, first of all, a sign that consumers have little buying power and companies have no scope to raise prices.

When prices fall, people and businesses delay purchases, because they expect things to become even cheaper. Corporate profits decline, and companies are forced to pay their workers less. A spiral begins that is difficult to arrest, as Japanese policy makers can attest. One reason that the European Central Bank maintains an inflation target of 2 percent is to provide itself with a cushion against falling prices.

Deflation could be particularly destructive in Europe, where governments, banks and private households are still struggling with excess debt. When companies and individuals earn less, they have trouble repaying their debts, which remain the same.

The euro zone has seen weak inflation before. The inflation rate was even negative for six months in mid-2009, during the sharp recession that followed the beginning of the financial crisis. But that was before the sovereign debt crisis had become obvious. And the European Central Bank had more room to cut the benchmark interest rate, which was at 2 percent at the beginning of 2009, compared with 0.5 percent now.

With the benchmark interest rate already at 0.5 percent, a record low, there are questions of whether another cut would have much effect on inflation. One benefit, however, could be a fall in the euro. Lower interest rates mean that investors earn less of a return on euros they hold, giving them an incentive to buy other currencies instead.

But some economists argue that the European Central Bank must go much further and buy large quantities of government bonds, as the United States’ Federal Reserve and the Bank of England have done to stimulate their economies when interest rates were already effectively at zero.

So-called quantitative easing would be highly divisive. Jens Weidmann, president of the German Bundesbank, has argued many times that the European Central Bank’s charter does not allow it to buy government bonds. And he is not likely to be alarmed about current inflation.

In response to a query, the Bundesbank said in a statement on Monday that its economists “see in their prognoses no deflation scenario for the euro zone.” It would probably take many months of negative inflation to convince skeptics.

Mr. Tilford of the Center for European Reform said that at some point the European Central Bank would have no choice but to buy bonds in a big way, despite what the rules say. “They will be forced into it eventually,” he said.

Even if deflation is not an immediate threat, the current low inflation rate is a clear sign that the euro zone recovery remains weak.

“The economy is not really getting going in the euro zone,” Friedrich Eichiner, chief financial officer of the automaker BMW, said during a conference call with journalists on Tuesday.

Mr. Eichiner said that he was not expecting deflation, which he called “an extremely pessimistic scenario.” But he added, “It’s necessary to make the right political decisions and create the conditions that allow companies to promote growth.”

This article has been revised to reflect the following correction:

Correction: November 6, 2013

An earlier version of a picture caption for this article misstated the given name of the president of the European Central Bank. He is Mario Draghi, not Maria