The perceived concern with low inflation or deflation in an economy is that it can act as a damper on demand since consumers may delay making major purchases in the hope that the cost may be lower at some future date. Whilst this argument doesn’t really hold with low inflation (since the prices are still rising albeit it slowly and therefore consumers will pay more if they delay their purchase), most central bankers see an inflation level of between 2 and 3% as being desirable for an economy.
Inflation as an average figure across the 18 nations in the Eurozone stands at 0.5%. In Spain, prices have actually been falling, but there and in Greece, the driver for higher consumer demand will be a reduction in the very high level of unemployment as the recovery finally takes a meaningful hold. The European Central Bank (ECB) has been suggesting that it will consider a more accommodative monetary policy if inflation remains very low.
ECB President, Mario Draghi indicated that a further strengthening of the Euro could act as a trigger for action. Perversely, a strong Euro means that imported goods and raw materials, priced in Dollars, are cheaper whilst the cost of exported Eurozone goods is higher. To an extent, therefore, a strong Euro means lower inflation since the cost of imports is lower.
The ECB has two obvious choices for easing its already (historically) lax monetary policy; either a further reduction in interest rates or the launching of an asset purchasing programme (Quantitative Easing QE). At the moment, the key interest rate sits at 0.25%, so there is scope for a further reduction. Some analysts have suggested that the rate could become negative (which was the case in Japan for some time) meaning that banks had to pay the ECB to leave funds on deposit with them.
The situation with respect to asset purchases (government bonds) is somewhat different to that facing other, national, central banks since the EU does not issue communal bonds. Creating an additional market for sovereign debt has the effect of pushing down the interest on bonds, easing the cost of long-term borrowing for a state. The details of how such a programme would work, and which states would benefit most, have yet to be thrashed out. QE pumps liquidity into the market through the commissions paid to the financial institutions that actually purchase the assets on behalf of the ECB (in this case). The idea is that these institutions can then lend out money to businesses. It is another case of “watch this space” to see what action, if any, the ECB deems necessary.