Risk of deflation in the euro area?

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November 4th, 2013

Inflation stands at a moderate rate in the euro area as a whole. In September it was 1.1% (October's flash estimate, 0.7%), but the downward trend occurring since the middle of last year is now leading to fears of possible deflation. Within a context where nominal interest rates cannot fall much further, a drop in inflation would push up real interest rates, making it difficult for the euro area to recover. Moreover, many countries must make a big effort to deleverage and low inflation rates would complicate this process even further. We will therefore analyse whether such fears of possible deflation are well-grounded.

In part, the drop in the rate of inflation occurring over the last few months is a reflection of the economic situation. Industrial capacity utilization remains at low levels: in 2013 Q2 it was 78.3%, 2.8 percentage points below its historical average. The labour market's situation is also keeping inflationary pressures very contained, with the unemployment rate remaining at around 12% this year, keeping wage increases moderate. We believe these factors will diminish as the upturn in activity gains ground over the coming quarters. Although the euro area's recovery is likely to be very measured and industrial capacity utilization and unemployment are therefore only expected to pick up gradually, what does seem clear is that these factors will stop pushing down the inflation rate.

There are another two elements that have also helped inflation to fall over the last few months: the trend in oil prices and the tax changes implemented in several countries in the euro area. With regard to first factor, one example is that the average price of Brent quality oil was 87.3 euros per barrel between January and September 2012 while in 2013 it has fallen to 82.1 euros. Given that, over the coming months, oil prices are expected to remain stable at their current rates, this should not be a factor that continues to push down the inflation rate. On the other hand, the last few months have seen a reverse in the effect of the tax hikes implemented in several countries in the euro area. One sign of this is that inflation at constant taxes, excluding energy products, has been more stable over the last few months (1.1% in September 2013 compared with 1.4% in January 2012). In other words, it has fallen by 0.3 p.p. as opposed to 0.9 p.p. for the general CPI.

In short, the fall in inflation observed over the last few months is due to transitory factors and the current situation. For deflation to occur, the euro area would have to enter recession again and, although the risks are still high, all the evidence suggests that the direction finally taken by the region is the opposite: namely recovery.