Today inflation in the Euro area is at dangerously low levels – 0.8% in the year to December. This is well below the target of 2% set by the European Central Bank. It doesn’t help that unemployment in the area is 12.1% and this will need to fall if there is to be some sort of recovery which will put upward pressure on prices. The ECB cut its Main Refinance Rate to 0.25% on 13th November last year and could be running out of options. It might be looking at imposing negative interest rates on deposits held at the ECB by trading banks.
Why is deflation a concern?
1. Holding back on spending: Consumers may opt to postpone demand if they expect prices to fall further in the future
2. Debts increase:
• The real value of debt rises when the general price level is falling and a
higher real debt mountain can be a drag on confidence
• Mortgage payers on fixed mortgage interest rates will see the real cost of servicing their debt increase
3. The real cost of borrowing increases: Real interest rates will rise if nominal rates of interest do not fall in line with prices
4. Lower profit margins: This can lead to higher unemployment as firms seek to reduce their costs.
5. Confidence and saving: Falling asset prices such as price deflation in the housing market hit personal sector wealth and confidence – leading to further declines in AD. Higher savings can lead to the paradox of thrift