At its most recent policy meeting, the European Central Bank eased monetary policy because inflation had drifted well below the ECB’s target. With economic activity weak, money growth slow, and commercial-bank lending sluggish, the risk of slipping into a Japanese-style deflation seemed plausible. Prices in the euro area increased an unexpectedly low 0.5 percent on a year-over-year basis in May, indicating that inflation has been moderating for the past 2½ years. Absent the volatile food and energy components, prices have risen just above their lowest pace since the euro came into being.
In response, the ECB lowered its key interest rates, which resulted in a negative interest rate on commercial-bank deposits at the ECB. The ECB will also institute some long-term lending facilities designed specifically to encourage bank lending to households and nonfinancial businesses and may initiate outright purchases of asset-backed securities. Hoping to keep inflation expectations anchored just below 2 percent, the ECB has promised to maintain its accommodative monetary stance until inflation moves close to that rate.
The ECB’s primary policy mandate is to maintain price stability, which it defines as an inflation rate below, but close to, 2 percent over the medium term. In its assessment of price stability, the ECB considers year-over-year changes in a weighted-average consumer price index covering the entire eighteen-country euro area. This is the Harmonized Index of Consumer Prices (HICP), which apportions weights according to the relative size of countries’ consumer expenditures. While the ECB does pursue other macroeconomic-policy objectives, like full employment and economic growth, these economic goals remain secondary to price stability.
This ordering of policy objectives reflects the view—one shared by most monetary economists—that maintaining price stability is the chief way that a central bank can contribute to long-term economic growth and to full employment. Changes in monetary policy, particularly unanticipated ones, might alter real economic activity in the short run, but not in the long run. The ECB’s current policy actions, however, support both long-term price stability and short-term economic growth.
The ECB is concerned that disinflation, if not addressed, could lead to a Japanese-style deflation—an outright decline in the HICP—that becomes imbedded in the public’s expectations and harms economic growth. It is a connection with a self-reinforcing potential. When individuals and businesses expect prices to fall, for example, they naturally postpone purchases and investments, if possible, but that only weakens economic activity and drives prices lower.
Deflation could also derail economic growth through its effect on the debts of households, businesses, and governments. Deflation increases the real burden of servicing debts, like credit cards, mortgages, and commercial loans. If debtors sell off assets to services these debts, asset prices can fall, causing losses and a decline in real net worth. Higher real debt burdens can also increase the incidence of default, which adversely affects financial-sector balance sheets and credit allocation. These developments, in turn, weaken economic activity, slow or contract money growth, and induce further declines in prices.
Fortunately, the ECB maintains a great deal of credibility with respect to its inflation objective. Over the 15½ years since eleven—now eighteen—European countries adopted the euro and a common monetary policy, the ECB has consistently delivered on its price stability pledge. Inflation has averaged 2 percent and has generally remained within a range of 1.2 percent to 2.8 percent.
Nevertheless, prices in the euro area have demonstrated some sharp, largely one-off, fluctuations, particularly during the recent financial crisis. Between late 2007 and early 2008, for example, the euro area’s HICP increased sharply, reaching 4.1 percent in July 2008 primarily because of rising energy, agricultural, and other commodity prices. By March 2009, commodity prices were declining, and the recession was reducing other cost pressures. By May 2009, prices began to fall, and in July 2009, the HICP fell 0.6 percent on a year-over-year basis. When a central bank has achieved a reputation for price stability, deviations like these do little to damage credibility.
Price patterns among the 18 member states show a wide divergence. In Greece, for example, prices fell 2.1 percent (year over year) in May, continuing a decline that began in October 2012. Cyprus and Portugal have also experienced deflation in recent months. Price declines in these distressed economies are part of the process through which they regain their competitiveness vis-à-vis the other euro-area countries. In Austria, at the other end of the spectrum, prices have recently been rising around 1.5 percent year over year.