Mario: don’t wait until you ‘see’ deflation

Draghi recently commented that ‘we are not seeing deflation’.  He elaborated.  They weren’t ‘seeing’ people postpone purchases until prices fell.  The ECB were ready to act [presumably when they did ‘see it’].  But there was no need to act further now.

A few points.

1.  It is probably too late if you wait until you are ‘seeing it’.  The time to act is before you see it.  Monetary policy works with long and variable lags, and has to be proactive as a consequence.

2.  The risks of deflation are tangible and mounting.  Analysts reckon that some of the fall in inflation in the euro area is temporary.  But there must be a risk that this fall causes panic, and detaches inflation expectations from the ECB’s target.

3.  This is especially true since the ECB don’t have a tried and tested way to loosen.  They seem unable or unlikely to try QE Fed or BoE style, because of the exposure to troubled ‘peripheral’ bonds that would entail, and the lack of any agreement, or a mechanism to facilitate one, to take such measures.  They could try Forward Guidance in the style of ‘lower for longer’.  But the effects of this are likely to be muted.  A low yield curve can’t be lowered all that much.  And having muddied the waters somewhat with Forward Guidance ECB-style, [which was about explaining what would happen anyway to rates, not marking a change in the reaction function] it doesn’t seem likely to me that a switch to lower for longer forward guidance could generate all that much of a change in the outlook for ECB rates, and may simply generate confusion.

4.  It would be nice if there were a coordinated fiscal polity able to loosen to make up for the impotence of monetary policy.  But of course there isn’t!  There are fiscal units within the euro area that are either insolvent, or close to it.  And Germany, which isn’t, would be averse to a further fiscal stimulus.

5. It’s possible that saying ‘we don’t yet see the disaster that would befall us if we were too late to act’ is a way simply to talk down the risks of deflation, since there is nothing further the ECB could do, or for which a consensus on the Council could be mustered.  If that’s the case, then it would be justified.  There may be costs to pay, if people come to understand that you don’t explain the risks how you see them, but how you want markets to see them.  But now may not be the time to worry about the finer points of time-consistent communication.  If diminishing the risks of deflation helps anchor inflation expectations and make deflation less likely, why not try it.

6.  Steve Williamson points out correctly that there is no coherent theoretical account of the supposed mechanism whereby deflation leads to a vicious cycle of ever lower output and lower inflation.  But personally, if I was a policy maker, with a voice on the ECB Governing Council, the lack of such a model would not convince me to be relaxed about the recent slide in inflation.