Economy

Eurozone deflation risk rises – is ECB forced to react?

Euroopan keskuspankki EKPLower than expected Eurozone inflation and increasing fear of deflation has prompted speculation the European Central Bank will be forced to deduct benchmark interest rate or to add fresh liquidity to the euro area financial system. 

Euro area annual inflation is expected to be 0.7% in October 2013, down from 1.1% in September, according to a flash estimate from Eurostat, the statistical office of the European Union.

Eurozone Consumer prices are rising at the slowest pace in four years. That is below the European Central Bank’s target of 2 percent.

Surprisingly low inflation will fuel the debate about deflation risk and whether the ECB can and should do something against it.

According to Nordea, the financial services group in Northern Europe, the decline in inflation was partly driven by lower energy prices.

“By the middle of October, Brent prices were almost 4 percent lower than in September in EUR terms. (Statisticians compare the prices prevailing around the middle of a month). They were down only 2% in USD terms. In other words, the stronger euro compounded the oil price effect on the inflation rate”, says bank on its Euro area Viewpoint report.

Nordea estimates, that oil prices – if not energy prices in general – should no longer dampen inflation in the Euro area. In Nordea’s  view, the current reading of 0.7 % is the low point at least for this year.

How bad are the falling prices for the Euro area recovery?

“Whether falling inflation is a bad thing for the economy, depends on the reasons and circumstances. For energy importers like the Euro area, lower oil prices mean a lower import bill and more money left to spend. However, the low inflation rate in general (not necessarily the recent drop of the inflation rate) reflects the underlying weakness of the economy and especially the labour market”, says Nordea.

“The low rate of inflation is a positive sign, as it is largely due to weak price pressure in the crisis countries,” says Christoph Weil, an analyst at Commerzbank AG in on Bloomberg interview.

Lower than excpected inflation and rising fear of damaging deflation has prompted speculation the ECB will invoke policies from a reduction in its benchmark interest rate to adding fresh liquidity to the financial system, or treasure bonds purchases similar to  U.S. Federal Reserve.

Nordea estimates, that the drop in inflation alone should not the push the ECB towards a rate cut. “In our view, it needs weaker business cycle indicators to make the ECB act. In any case, pressure on the ECB is rising.”

Deflation means a general decline in prices, often caused by a reduction in the supply of money or credit, or by a decrease in government, personal or investment spending.

Persistently declining prices are extremely dangerous to whole economy. Deflation can create a vicious spiral of shrinking employments and incomes, falling profits and increasing defaults on loans by companies and individuals.

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