Certainly, headline inflation has turned negative in the euro area since December 2014. In February 2015 all the euro area members but Austria and Italy registered negative year-on-year price changes, while only Greece and Spain had negative inflation in October 2014. This fall in prices largely reflects the impact of one of the largest declines in oil prices in recent decades. Despite a partial rebound in February-March, oil prices are now still about 30% lower than at the time of the OECD’s November outlook.
Such lower oil prices have increased the risks that inflation will remain far below the European Central Bank (ECB) target for an extended period as well as the dangers associated with the excessively low rates of inflation.
However, the risk of prolonged deflation is far from certain. After all, lower oil prices are also bolstering growth in the euro area by increasing real household income. Indeed, consumer sentiment and retail sales have improved in recent months. The combination of this support and the shift to more aggressive quantitative easing (QE) by the ECB has led the OECD to revise its growth forecasts for the euro area upwards from 1.1% to 1.4% in 2015 and 1.4% to 1.7% in 2016. This higher activity should relieve deflationary pressures as QE continues, and economic slack is reduced by stronger growth. Moreover, the sharp euro depreciation, while making exports more competitive, will reduce slack more as well as push import prices higher. The consumer price index could tick up before the end of the year to reflect these factors.
While the bold ECB easing was warmly welcomed given the below-target inflation and persistently weak output, today’s abnormally low interest rates and QE raise the possibility of excessive risk-taking with new liquidity, and consequently asset prices reaching new highs. The remarkable fact that a growing number of national governments are able to sell medium-term bonds at negative nominal interest rates–meaning that investors effectively pay to invest in such bonds–shows how exceptional current circumstances are. And these abnormal terms and risk premiums are not limited to the euro area.
Highly accommodative monetary policy remains necessary to fight deflationary pressures, but the increased financial risks associated with such a stance and the failure (so far anyway) of monetary easing alone to spur strong growth in business investment call for other mutually reinforcing measures: namely, balanced packages that combine fiscal, structural and monetary policies. In short, while lower oil prices and the cheaper euro may offer the euro area escape from stagnation, they should not be allowed to slow reforms aimed at bolstering performance and addressing the causes of the crisis.
This article was prepared by the OECD Economics Department for the OECD Observer, March 2015.
Stephanie.Guichard@OECD.org can be contacted for further commentary.