To the shock of many, the ECB decided to act sooner than predicted and promptly lowered the base rate on the euro from 0.5% to 0.25%. The ECB felt forced to act as inflation has plummeted from 2.2% in January to just 0.7% this month (it was as much as 1.6% in August). With such a sudden decline in just a short period of time, the spectre looms of potential deflation and Super Mario felt the need to act now before it was too late. The euro instantly dropped over 1.5 cents against both the dollar and pound.
Whilst for most people the idea of no inflation sounds like a good thing (after all doesn't it mean things start to cost less?) on the whole broad deflation, if sustained, can be worse in many ways than a higher inflation rate. Robert Peston goes into the consequences of deflation (as well as the impact of ECBs cut on the UK) quite well in his blog on Thursday and it is worthwhile read. As he describes "If businesses and consumers began to believe that deflation was a serious prospect, they would defer purchases and investments to take advantage of falling prices.........there would be an even greater incentive for businesses, households and banks to reduce their debts - to save as if there's no tomorrow - because of the threat of deflation increasing the real burden of those debts"
If you believe the price of something is going to reduce, then you will wait for it to cost less before you buy it. Of course if you delay too long on your purchases then the economy itself will suffer as companies begin to stutter again as they struggle to cover their costs. They will then seek to reduce costs, which itself could be a reduction in staff or reduction in wages paid to staff, again reducing the income the population has to spend on items further depressing the situation. Meanwhile, in a similar vein that the value of money becomes less over time due to inflation, the opposite is true during a deflationary period. Any debts will begin to increase in value, unless they are paid off, and people will be tempted to put all their money under the mattress to save for when things become even more affordable (and avoid suffering deflation on investing it). The more money stored and saved up by people and companies, means less money spent on investment of any kind which ultimately becomes detrimental economic growth. Once deflation hits, the downward spiral it causes can be difficult to find a way out of, as Japan has found over the last 2 decades.
Given how depressed the Eurozone economy has been over the last few years, especially in the periphery, it might come as a surprise to many that the ECB has waited so long to drop it's base rate. The policy direction of the ECB now however points to significant divergence between the 3 main western monetary policy makers. In the US, talk continues apace about the possibility of the Fed beginning their taper of QE as early as December as GDP looks like growing over 2.5% for the year. Meanwhile the UK's economy continues to speed up with some analysts predicting it will have shown an increase of over 3% for the whole of 2013. Meanwhile the UK has not introduced any additional QE stimulus from its targeted £375bn total it has had for many months and the most recent forward guidance from Mark Carney had indicated the status quo would remain for at least another couple of years. Should the UK continue on it's current trajectory there is every possibility that the Bank of England may feel the need to tighten sooner, especially should inflation also continue to remain close to 3%.
The recovery in both the UK and US is however still tentative. In the US, the continuous threat of no real resolution on the US budget deficit and debt ceiling overhangs any recovery. Whilst here in the UK further failing retail companies (with Blockbuster and Barretts amongst the latest to go back into administration) show signs that we're still not out of the woods. However at least compared with the Eurozone there appears to be some form of recovery which can be used as a platform to move forward. The lack of real performance across the eurozone makes it a realistic prospect that rates in Europe will not only remain even lower for the foreseeable future but the ECB may need to rewrite the rulebook as a last ditch action to prevent deflation if the latest rate cut fails to work.
This may be easier said than done, if the Germans decide to put their foot down. Germany is especially fearful of the consequences that inflation, and specifically hyperinflation could result in, which is understandable given it's own fight with it in the 1920s and the devastating ultimate consequences of that. Whilst a focus on history can be useful in helping to make wiser decisions, too much obsession in attempting to relate history to the present can be to the detriment of the present and future. The ECB has already shown itself to be sluggish to react at times to it's recent troubles acting with caution where it's fellow central bankers abroad have been more decisive. Germany will need to accept that being part of a union requires accepting what is best for that union as a whole. The ECB has tried to act quicker this time to ensure it will stop deflation before it is too late and hopefully help stimulate the eurozone recovery as an additional consequence. Any further dithering resulting from internal national differences may not only see the eurozone left behind in any recovery but worse still could drag the US and especially UK economies back down with it.
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