Economic update: Lower inflation is bad news for Europe

The latest data shows that inflation in the Eurozone has dropped to 0.8% on a year-on-year basis, which is significantly lower than the European Central Bank’s (ECB) target of “below 2 %”. This, coupled with a weak recovery in some peripheral economies, raises the possibility of deflation taking hold. So what would be the implications of this, and what does it mean for the Eurozone’s recovery?

One side-effect is consumers postponing spending as they wait for prices to come down in the future. This is more relevant for peripheral economies which are already experiencing a significant contraction in domestic demand. A short-term decrease in consumption could exacerbate this trend and increase their reliance on external demand as the main source of economic growth.

A second implication of negative inflation is that it pushes up real, or inflation adjusted, interest rates. Businesses in the periphery are already under pressure as they pay higher nominal interest rates compared to their competitors in the core. Higher real interest rates (see figure 2), could deter them from taking part in longer term investment projects altogether. 

The analysis above shows that businesses in the periphery continue to be under severe stress even though economic growth is turning more positive.

Figure 2: High real interest rates are a burden on the peripheral economies