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21 January 2014

The Ogre Stalking the Eurozone 

The European Central Bank’s (ECB) goal is to limit inflation in the eurozone to 2% a year. With eurozone inflation estimated at an annual 0.8% in December, is it doing its job too well?

While inflation devalues currencies and degrades the value of savings, deflation both stems from and intensifies a lack of demand for goods and services that fuel the economy of a country, or a continent.

Though prices are technically rising across the eurozone, debt deflation is already in play. Bonds that were issued anticipating a 2% rate of inflation are more expensive to pay off when inflation is only half that rate.

Complicating the situation for the eurozone is that the euro, like the US dollar, is a safe-haven currency for nervous investors when they shift from more risky assets into cash. Increased demand for euro-dominated securities drives up the value of the currency and makes European goods more expensive on global markets.

With inflation in the bloc at a four-year low, calls are growing for more vigorous intervention to stimulate demand, which would also fuel economic growth. Christine Lagarde, managing director of the International Monetary Fund, says she fears the “ogre” of deflation much more than letting the “genie” of inflation out of the bottle.

Demand should recover anyway as economies emerge from recession. That may explain the ECB’s reluctance to intervene more forcefully in economies that might naturally recover on their own, especially when interest rates are already at historic lows.

But persistently high unemployment and slow economic growth in much of the eurozone, especially countries hard hit by the debt crisis, may create political pressure for more decisive action to encourage growth and banish that deflationary ogre.