18/11/2013 06:28 GMT | Updated 23/01/2014 18:58 GMT

Swift ECB Action Aims to Defuse Deflation Risk

The decision by the European Central Bank (ECB) to cut its policy rate by 25 basis points to 0.25% on November 7th demonstrates that the bank takes the risk of deflation seriously. But despite the ECB's action, economic recovery prospects remain fragile and financial fragmentation in a diverse currency union is set to continue, as the monetary transmission mechanism is still impaired. Further ECB moves into unchartered territory are possible, and national governments will have to build stronger federal structures to avoid a resurgence of the euro crisis.

Average euro zone inflation was a provisional 0.7% in October, much weaker than the ECB's official target of "close to but below 2%". It is not just the low level of inflation that has been a concern for the Bank, but the rapid decline in recent months: between July and October the rate fell by 0.9 percentage points, from 1.6% to 0.7%.

There is significant diversity in the euro area. Peripheral crisis countries are undergoing "internal devaluation", slashing inflation mainly via demand-driven factors such as rising unemployment and austerity that have led to lower wages, pensions and liberalisation of some product and service markets. These countries, including Greece and Spain, have seen a much more rapid decline in inflation than "core" countries such as Germany where disinflationary pressures have stemmed mainly from supply-driven factors such as lower commodity prices.

Why deflation is such a major risk

In relatively "normal" economic times, falling prices are not necessarily a cause for concern, for example when supply shocks lower commodity prices and thereby reduce companies' input costs and raise household purchasing power. However, in the euro area today the supply-side effects from lower global commodity prices are accompanied by severe demand-side shocks caused by the need for deep austerity to reduce high debt levels in the wake of the global financial crisis and subsequent sovereign debt crisis. Lower wages and falling house prices have reduced households' ability to service their debt in both the euro zone "core" (such as the Netherlands) and the "periphery" (such as Greece). In turn, higher levels of non-performing loans put banks' solvency at risk, causing banks to tighten credit conditions further and depriving households and companies of much-needed credit.

The prospect of deflation can also become a self-fulfilling prophecy. In anticipation of falling prices, companies and households could defer some non-essential purchases and investment, thus reducing domestic demand sharply. The incentive to save rather than spend would also increase given that the real burden of debt rises when inflation falls.

All this is happening against a backdrop of tightening fiscal policies across the euro area in an attempt to boost public finances. As with consumers, companies and banks, falling inflation makes this task even more difficult for national governments as the real burden of debt rises. Hence, the need for austerity is prolonged and/or deepened further.

Disinflation also boosts the value of the euro, thus making exports more expensive and reducing the ability of countries to benefit from an export boom to offset the decline in domestic demand. The ECB did not mention the exchange rate when it lowered the policy rate in November, but it is likely that the decision was, at least in part, motivated by the sharp increase in the euro's value against the US dollar in recent months.

Financial fragmentation

The biggest problem in the euro area is its heterogeneity and the concomitant difficulty in setting a monetary policy that suits all 17 members. While the ECB's monetary policy may be too loose for the likes of Germany, where unemployment stands at its lowest level in over 20 years, it has been too tight for the euro area's struggling periphery.

In the crisis countries, bank funding costs have risen, with weak demand for loans, balance-sheet deleveraging and elevated credit risk raising retail interest rates. The monetary transmission mechanism continues to be ineffective, thus lowering loan availability for credit-starved households and companies in the periphery.

Aware of the dysfunctional monetary transmission mechanism, the ECB has tried to ease funding pressures by extending at its November meeting the provision of unlimited short-term liquidity to July 2015.

The ECB's limitations

However, the ECB decided not to cut the deposit facility rate--the interest rate the ECB pays on banks' reserves parked at the central bank--from its current level of 0%. Under the current policy of "full allotment" of liquidity at fixed rates, the deposit rate has become the most important determinant of market interest rates, with the overnight interbank lending rate, EONIA, a little above zero. A lower refinancing rate helps banks in the periphery that rely largely on ECB liquidity, but has little impact elsewhere, since the deposit rate is unchanged at 0%.

Cutting the deposit rate would be a big gamble. ECB president Mario Draghi did mention the option of taking the deposit rate into negative territory, thus charging lenders to hold funds at the central bank. A cut would aim to discourage banks from holding so much cash with the central bank, but it could also cause even higher retail interest rates as banks pass on some of the costs to customers. Hence, negative deposit rates appear unlikely in the near term, but remain a potential weapon in the ECB's arsenal. Moreover, the ECB may still implement another longer-term refinancing operation (LTRO) early next year, especially as banks shore up capital and deleverage further amid the ECB's asset quality review.

However, the euro zone's prospects still rest to a greater extent on the actions of its political leaders than on those of its leading central banker. Although the ECB has, in theory, given member states more breathing space to put the euro area on a sounder structural footing, governments have so far failed to agree moves to turn the euro zone into a proper federation, for example, a fully fledged banking union.