Euro Area — “Deflation” Versus “Lowflation”

By Reza Moghadam, Ranjit Teja, and Pelin Berkmen

Recent talk about deflation in the euro area has evoked two kinds of reactions. On one side are those who worry about the associated prospect of prolonged recession. On the other are those who see the risk as overblown. This blog and the video below sift through both sides of the debate to argue the following:

  • Although inflation—headline and core—has fallen and stayed well below the ECB’s 2% price stability mandate, so far there is no sign of classic deflation, i.e., of widespread, self-feeding, price declines.
  • But even ultra low inflation—let us call it “lowflation”—can be problematic for the euro area as a whole and for financially stressed countries, where it implies higher real debt stocks and real interest rates, less relative price adjustment, and greater unemployment.
  • Along with Japan’s experience, which saw deflation worm itself into the system, this argues for a more pre-emptive approach by the ECB.

I. Is there deflation?

Mario Draghi has described deflation in the euro area as a situation where price level declines occur (1) across a significant number of countries; (2) across a significant number of goods; and (3) in a self-fulfilling way.

By this definition, the term "deflation" is arguably overstatement.

First, on geographical scope, recent price changes have been positive in all but 3 countries (versus 12 countries as recently as 2009).

EUR Update_Feb2014_Deflation Blog.002

Second, regarding incidence across goods and services, outright price declines account for only a fifth of the HICP basket — not a high share and, again, no more than in 2009, when the event passed without deflationary consequence.

EUR Update_Feb2014_Deflation Blog.003

Third, is there is a "self-fulfilling" dynamic in the sense that expected future inflation is dragging down current inflation? Here the answer is less obvious. If by expected future inflation we mean longer term rates, then the answer is no: expected inflation 5-10 years out is flat and so could not possibly be the cause of falling current inflation. But if we consider 2-4 year ahead expected inflation, the horizon relevant for many spending decisions and wage negotiations, these are falling and could be affecting current inflation. That said, actual inflation stabilized in February at 0.8%.

EUR Update_Feb2014_Deflation Blog.004

II. But if it’s not “deflation”, what’s the problem?

In the current European context, even very low inflation can scupper the nascent recovery and pressure the most fragile countries.

Problem #1

Both deflation and less-than-previously-expected inflation increase the real burden of existing debt and the real interest rate that borrowers pay. As it happens, the countries with deflation/low inflation, marked red in the chart below, also happen to be the ones with already higher debt burdens (private + public) and real rates, and include all the countries that have been under market pressure during the crisis.

EUR Update_Feb2014_Deflation Blog.005

Problem #2

While deflation/lower inflation in high debt countries is painful to them, at least it improves relative prices, and hence exports and current account sustainability. Unfortunately, when inflation turns low everywhere in the euro area, each unit of deflation/low inflation endured by indebted countries delivers less price adjustment relative to the surplus countries. Or put another way, each point of relative price adjustment must be bought at the cost of greater debt deflation.

Problem #3

When demand drops and nominal wages are sticky, the hit to unemployment is cushioned by any on-going inflation, which effectively lowers the real wages that firms pay. That cushion is now badly needed. In Spain, we see in the next chart that, after the crisis, the wage distribution slammed against the zero-barrier, with 30% of the distribution concentrated there. Given sticky nominal wages, near zero inflation in Spain is not helping to resolve the severe unemployment problem there.

EUR Update_Feb2014_Deflation Blog.006

III. What are the lessons from Japan’s experience?

There are at least two.

Lesson #1

One should not take too much comfort in the fact that long-term inflation expectations are positive (over 2% in the euro area). Long-term inflation expectations on the eve of three deflationary episodes in Japan were also reassuringly positive. But nearer-term expectations turned more pessimistic, feeding into spending and wage decisions and delivering actual deflation. Long-term expectations adjusted too little and too slowly to be a useful guide to monetary policy. The takeaway: not-so-long-term inflation expectations, which we saw are falling in the euro area, also need to be given due consideration.

EUR Update_Feb2014_Deflation Blog.008

EUR Update_Feb2014_Deflation Blog.009

Lesson #2

One needs to act forcefully before deflation sets in. As shown below, the Bank of Japan was relatively slow in lowering policy rates and ratcheting up base money. In the event, it had to resort to ever-increasing stimulus once deflation set in (shaded grey areas in the second chart). Two decades on, that effort is still ongoing.

EUR Update_Feb2014_Deflation Blog.010

EUR Update_Feb2014_Deflation Blog.011

IV. Conclusion

You can have too much of a good thing, including low inflation. Very low inflation may benefit important segments of the population, notably net savers. But in the current context of widespread indebtedness problems, it is working to the detriment of recovery in the euro area, especially in the more fragile countries, where it is thwarting efforts to reduce debt, regain competitiveness and tackle unemployment. The ECB must be sure that policies are equal to the tasks of reversing the downward drift in inflation and forestalling the risk of a slide into deflation. It should thus consider further cuts in the policy rate and, more importantly, look for ways to substantially increase its balance sheet, be it through targeted LTROs or quantitative easing (public and private asset purchases).


2017-04-14T02:09:58-05:00March 4, 2014|


  1. Eric March 5, 2014 at 10:49 am

    Does anyone else find it amazing that in the graph under “Problem 1” showing real interest rates, Greece’s actual interest rate is not only above the graph, but is plotted above even the title of the slide?

  2. H.Publius (@HPublius) March 6, 2014 at 7:18 am

    Another problem with low inflation is that it may be partly a source of wage rigidity. By not allowing prices to fall, central banks may also be preventing a decline in wages. This is a scary prospect due to the self-reinforcing nature of such causality. It also implies that the mechanism for internal devaluation may be broken, which leaves EU periphery with little hope for quick recovery. I am curious if someone has looked into wage rigidities during the Great Depression and how they compare to current experience. Back then central banks were unable to prevent deflation due to gold standard, and nominal wages did fall (albeit not to the same extent as nominal prices).

    Please note that at the lower zero bound, central banks can prevent declines in prices by providing sufficient liquidity, but are unable to induce inflation, because the public can arbitrage their negative expectations of the future (negative ROE) by simply holding money at 0%. This condition has been described with many labels – liquidity trap, pushing on a string, infinite liquidity preference. The experience in the US where three rounds of QE produced little to no inflation is instructive.

    Bold measures are needed to break free from the lower zero bound. Here (, I describe an idea which calls for equipping the ECB with new tools in the form of consumption and investment credits. Such tools can act as a fiscal stabilizer and provide the ECB with flexibility to customize monetary policy to the needs of each member country. More importantly, it will lay the foundation for resolution of bad sovereign debts – the lack of such mechanism being the fundamental design flaw of the euro.

  3. Kit Kat March 12, 2014 at 5:34 am

    I think deflation will not happen in the euro region; the currency should start to depreciate quite a bit some time soon.

  4. Moon Oulatta March 12, 2014 at 11:31 am

    During the mid 90s the U.S experienced a period of low inflation, and high employment due to high productivity growth, so as far unemployment concerns, one must analyze the data carefully, obviously deflation is something to be concerned about as far what it does to the real interest rate and consequently domestic investment(especially residential investment ). Plubuis I agree that low inflation may be a source of wage rigidities, as wages may be sticky in these days of uncertainty, but low inflation may also be the result low growth followed by strong austerity policies taken in the Europe and by the way the Euro zone is not yet in the liquidity trap, but the European central bank must remain attentive to what happens to real money balances, they must avoid any sporadic contraction of real money balances. I am optimistic though, as far low inflation(not deflation), I think that it could be a boost for Europeans exports, as their goods become relatively cheaper.

  5. Fabio Drago March 27, 2014 at 3:19 pm

    In my opinion a healthier debate on inflation/deflation should try to address a bit more the origin of each price variation and not to be limited to the algebraic sum of all the price variations. In a touristic area, for instance, in case the number of tourists grows we can expect an increase of the prices. If the price of the oil in a country that imports it increases, we can expect an increase of the prices. Both phenomena provoke inflation, but it is not the same inflation for people living in these places. The second type of inflation will affect everybody the first type of inflation would affect only the households with a fix income. On the other hand, an increase of the competition, for instance the increase of taxi drivers, may reduce the price per kilometre to be paid, while a reduction of the prices due to an increase of unemployment may have a “deflation” effect on the economy, but in the first case most probably everybody will be happy, while in the second case there is no reason to be happy.
    For instance in Italy we can observe that the prices paid by the Public administrations in the Southern part of the country is well above the prices paid in the North (a recent study of the Confcommercio) and this is equal to extra costs equal to 83 billion Euro. In other words, these 83 billion Euros determine an increase of the inflation. Additionally, the public debt of the country and its connected increase of the cost of money have also an effect on the increase of the prices of the goods and services due to a worsening of the cost of the working capital of the enterprises. At the same time the increase of the unemployment reducing the consumption of the families push the prices towards a lower level. These three phenomena are negative for the economy of the country, but their effects on inflation/deflation are opposite. Well, all these tensions on the level of prices in part compensate each other, but the final result that we can observe is not any more giving us any relevant information. Most probably Italy is already to be considered in deflation

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