Briefing: Eurozone succumbs to deflation

The eurozone's struggling economy has succumbed to deflation for the first time since 2009. Kam Patel looks at what deflation is, what's caused it, and why it could be dangerous.


Mario Draghi of the ECB is under pressure to stimulate the economy and combat deflation

What's happened?

It emerged this morning that the struggling eurozone economy has succumbed to deflation, or falling prices, for the first time since 2009.

Prices across the region in December were 0.2% lower than in the same month a year earlier.

What's caused it?

The eurozone's slip into deflation fall was driven mainly by lower energy costs due to a slump in oil prices. Energy prices in December were 6.3% lower than a year earlier. If energy prices are excluded, December's inflation rate for the eurozone was 0.6%, the same as in November. However, food prices were flat versus last time, and experienced deflation earlier this year, indicating the decline cannot be attributed to fuel alone.

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What is deflation and how dangerous is it?

Deflation is the opposite of inflation, with prices falling rather than rising, giving rise to negative inflation. It's bad news because falling prices mean lower profit margins for companies, which can force them to peg wage rises, lay off workers, and engage in price wars for their goods to remain in business.

At the extreme, deflation can lead to everybody consumers and companies alike not buying things on the very real expectation that they will be cheaper tomorrow. Nobody wants to be in a position where, for instance, they might buy a house one day and find they have already lost money on it the day after: buyers would much rather wait for prices to bottom out.

What will the EU do about it?

Today's data heaps more pressure on the European Central Bank (ECB) to announce measures to stimulate the eurozone economy at its 22 January meeting.

The ECB has already initiated several steps to drive inflation higher and avoid deflation, but clearly they have not been enough. Now the pressure will be on the Bank to engage in the full blown quantitative easing (QE) programme, in line with what has already been undertaken in countries such as the UK, US and Japan.

Only last week ECB president Mario Draghi indicated that a QE programme for the eurozone is being considered.

Is QE a good idea?

Well, after today's inflation data, QE it looks to be about the only realistic option left open to the ECB. The bank has, since the 2007 crisis, taken several small-scale steps to loosen monetary policy (beyond ultra-low rates) to spur growth across the eurozone. But these have had very limited success, and markets are now anticipating the bank will have to engage in a QE programme that involves it buying up sovereign bonds of eurozone members. Such a move could amount to a trillion euros being pumped into the eurozone economy.

But, as The Economist points out, purchasing sovereign debt is highly unpopular within Germany where it is seen as trespassing on fiscal policy. Imposing QE on a reluctant Germany risks a dangerous confrontation with a country that underwrites the monetary union.

What the experts say

Samy Chaar, chief economist at Lombard Odier, says today's eurozone data looks a little more alarming than it really is because of the impact of falling oil prices on the reading. He adds: "Nonetheless, this forces the hand of the ECB. The data still makes the case for Draghi to act because of recent signals [from him] and market expectations."

James Ashley, chief European economist at Capital Economics, says arguments over whether inflation was just above or below 0%, and whether the tumbling oil was to blame, are "specious".

"The far more important question is why inflation is anywhere near 0% in the first place: in our view, the inconvenient truth for policymakers is that, in large part, that is a reflection of the failure of policy, both fiscal and monetary."

Howard Archer, chief European economist at IHS Global Insight, meanwhile, told The Guardian: "While the ECB would normally look through any drops in the headline inflation rate resulting from sharply falling oil prices, the bank will be seriously concerned that the move into deflation in December will lead to a further significant weakening in inflation expectations that then feeds through to result in renewed drops in already worryingly low-core inflation."

What QE means for investors

Quantitative easing involves a central bank buying up government securities or other securities from the market in order to increase the money supply. In effect, QE floods financial institutions with capital in an effort to promote increased lending to individuals and liquidity.

The idea is that the capital should leak from institutions into the greater economy through lending but one of its most powerful, direct effects is that the selling institutions will use the funds secured to invest in fresh assets globally, pushing up stock markets. That is good news for investors as they will enjoy a rise in the value of their holdings.

Kam Patel

Kam is a former deputy editor at Hemscott Invest and online editor, City A.M and he was also previously the Digital Editor at IFA Magazine. Kam is currently a senior journalist at The Global Treasurer and contributes to MoneyWeek. Kam shares expertise on the FTSE 100, investing and global stocks.