Europe’s Slow-Motion Descent Into Deflation

The Eurozone economy seems to be slipping ever so slowly into a deflationary trap, which means that the European Central Bank (ECB) needs to react. The crowd’s expecting no less via a formal announcement later this month from the ECB. But the political pressure in Europe (primarily due to Germany’s hefty influence on monetary matters) suggests that a new phase of stimulus may be dead on arrival. As such, the global economy may be facing stronger headwinds this year if Europe’s malaise deepens.

This much is clear: Europe desperately needs a stronger degree of monetary stimulus, in part because the central bank was slow to react to the macro blowback from the 2008-2009 financial crisis and recession. ECB President Mario Draghi’s “do whatever it takes to preserve the euro” speech in July 2012 was a turning point that signaled a shift to promoting growth over fighting inflation. But the change in priority has unfolded slowly, in degrees, dispensing marginal results at best. Indeed, Eurozone inflation in November dipped into negative territory on an annual basis (-0.2%) last month for the first time in five years while growth remains tepid at best. The trend is deteriorating and more of the same is likely in the near term.

The market’s expecting that the ECB will respond later this month by rolling out a full-blown program of QE–quantitative easing or monetary stimulus by way of buying government bonds. But expectations probably exceed reality in terms of what can be achieved at this late date for at least two reasons:

Institutional denial. Several key policymakers at the ECB continue to argue that the ECB doesn’t need to embrace a more muscular program of stimulus. For instance, last week a member of the ECB’s executive board remained “unconvinced” that stronger monetary stimulus is needed. Instead, Sabine Lautenschläger said in an interview with Der Spiegel that “what we should do instead is wait until the measures that we have put into place only recently can take full effect.” But waiting (and hoping) at this late date is highly risky. Yet despite clear evidence that Europe is increasingly at risk of slipping over to the dark side, many policymakers argue that there’s no reason to act.