As expected the euro area went into deflation in December as inflation fell to -0.2% y/y. It is likely to move even further into negative territory in coming months – we expect -0.5% in March. However, it is important to stress that this is not the dangerous kind of deflation. On the contrary it is currently giving a boost to growth. There are basically two kinds of deflation: Good deflation, which is driven by improving productivity, and bad deflation which is driven by weak demand. Fortunately it is mainly the good kind we are experiencing at the moment. The productivity gain inducing deflation stems from the improving technology in oil production which has led to the shale oil boom in US and other countries. This has led to a sharp increase in oil supply and since OPEC has refused to cut supply in response, oil prices have collapsed. Part of the decline is also due to weak demand, but it seems plausible that the main part comes from higher supply. Otherwise the oil price decline would be more gradual and not the big drop we have seen lately.
The lower oil prices have translated into considerably cheaper gasoline and also underpinned the move lower in food inflation. Both factors free up purchasing power for consumers and are an important explanation of why euro area private consumption has been so resilient this year. Strong euro retail sales this week gave more evidence of this as they showed a decent rise of 0.6% m/m in November for the second month in a row, see Flash Comment: decent euro retail sales with more to come, 8 January 2015. An easy way to measure whether it is good or bad deflation is to look at real wage development. If deflation was due to weak demand it would be driven by declining real wages and thus nominal wages would also be falling. However, this is not the case. On the contrary, real wage growth is rising around 1½% which is about the fastest pace since 2009 at which time the euro area also saw oil-price induced deflation. Although nominal wage gains are moderate at the moment, at 1.3% they are still not in negative territory.
The negative inflation does pose a clear risk of de-anchoring inflation expectations and the ECB has to react to this. It seems increasingly likely that the ECB will announce a QE programme in government bonds on 22 January. The ECB’s Coure said on Thursday that monetary policy must react to the inflation drop, and the Greek situation is not a reason to delay the ECB decision. The ECB president has sent similar signals lately. Rumours reported on newswires on Friday were that an ECB staff study was presented to policy makers on 7 January outlining a plan for QE with investment up to EUR500bn in investment grade government bonds.
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