Creeping deflation threatens eurozone but ECB’s hands are tied

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While the threat of deepening deflation hangs over the eurozone, the European Central Bank’s hands are tied leaving it helpless to tackle the situation in the short-term.

Euro area consumer price inflation has been on a downward trend for the past two years and this trend is expected to continue as lower unit labour costs and the ongoing structural reforms to liberalise markets, which generate price competitiveness and drag down inflationary pressures. 

Legal & General Investment Management’s European economist Hetal Mehta says: “The prolonged period of unemployment in Europe has added to deflationary pressure as lower employment has fed through to lower consumer demand.”

Mehta notes the euro has appreciated significantly over the past year, reducing import prices and hence pushing inflation even lower. As a result, Mehta forecasts core inflation in the eurozone will average just 0.4 per cent in 2014 with headline inflation around 1 per cent.

“The pain of a period of sustained deflation, or even low inflation, will be felt most acutely by countries with high debt levels – found in ample supply in Europe. Without the ability to inflate away the real value of debt, governments will come under greater pressure to proceed with aggressive austerity which could trigger a vicious spiral of further economic weakness and a renewal in debt sustainability fears,” adds Hetal.

But this leaves the ECB with a conundrum as unlike the Fed or the Bank of England, the ECB is constrained by the competing interests of the different member states.

She adds: “The ECB ultimately has a choice between preserving the purchasing power of savers in core euro area countries or keeping conditions for periphery sovereigns supportive. Overall, we think the ECB’s monetary policy response will be limited.

”A further, small reduction in interest rates is possible by the end of this year but noteworthy action is only likely on evidence of a prolonged deflationary period or if the growth outlook deteriorates significantly relative to the ECB’s already conservative forecasts.”

Notably, the embattled eurozone was hit with further negative news today as the cost of borrowing in Portugal was pushed upwards as the political and economic turmoil engulfing the country deepened. Ten-year government bond yields rose to 8.2 per cent, their highest since November last year while two-year yields increased to 5.47 per cent. In addition its stock market, the PSI 20, collapsed as investors sold-off riskier assets on the back of concern over the dire state of the nation’s economy and debt.