Eurozone inflation drop seals deal for ECB

Tuesday, June 03, 2014

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FRANKFURT, Germany — ANOTHER unexpected drop in inflation in the 18-country eurozone has made it a near certainty that the European Central Bank will act this week to support the economy.

The annual inflation rate fell to 0.5 per cent in May, below the 0.6 per cent that markets expected, the previous month's 0.7 per cent -- and way, way below the ECB's goal of just under two per cent.

The worryingly low figure has stamped out what few doubts may have been left that the ECB will loosen its monetary policy at its monthly meeting Thursday by cutting interest rates, and possibly more, to try to boost a weak recovery that's fraught with worries.

ECB President Mario Draghi has said that the bank's 24-member governing council is "not resigned" to the current low rate of price rises, raising expectations of some kind of policy action.

Here's what the bank might do, and why low inflation is a problem.

Inflation that's too low -- close to zero -- is often a sign of a weak economy, and can be accompanied by high unemployment, such as the 11.7 per cent rate in the eurozone.

In Europe, low inflation makes it harder for companies and countries to work off large levels of debt they were saddled with during the continent's economic and financial crisis that saw debt burdens soar.

It also makes it harder for troubled countries in the eurozone to become more competitive in international trade by lowering their costs of doing business.

For instance, Greece wants to become competitive by reducing the cost of its exports relative to other countries. Low inflation in its trading partners in the rest of the eurozone, however, means the reduction must be even deeper, through spending and wage cuts. And more cutslike that in turn hurt growth -- a bad spiral to be in.

Even worse than low inflation is outright deflation -- where people come to expect prices to fall and put off purchases and investment, choking off growth. That is a disaster scenario the ECB wants to make sure does not happen.

Much of the drop in inflation is due to low energy and food prices, compounded by the strength of the euro against the dollar. That lowers the prices of imports -- particularly energy, which is generally priced in dollars.

More than that, at least some of the low inflation was sought deliberately by some countries. Those that got into trouble with too much debt and had to be bailed out -- such as Greece, Ireland, and Portugal -- were told to make big cutbacks as a condition of rescue loans from the other eurozone countries and the IMF. They reined in spending and government wages.

The ECB's main tool -- cutting interest rate -- has gone about as far as it can. The ECB has lowered the rate at which it loans to banks to 0.25 per cent.

Analysts think it will cut that rate again, possibly to 0.1 per cent.

Then things might get more unorthodox.




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