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18 September 2015

CEPS: What signal from the Fed? Should the ECB ease further?

The Federal Reserve left rates unchanged at its closely-watched meeting. No similar decision on exit is in sight in the euro area, despite the fact that some have argued that the ECB should consider further easing measures.

Inflation in the euro area remains stubbornly low. The headline consumer price index hovers around zero and even core inflation remains below 1%, which might be due to the second bout of weakness in oil (and other commodity) prices this year. Inflation is falling across the globe, and deflationary tendencies remain even in the longer-term expectations as the inflation expected five years out is also falling. But are lower oil prices a sound reason for central banks to keep monetary policy easier for longer?

The Federal Reserve left rates unchanged on September 17th, although many had argued that the real economy data, especially on the labour market, would have justified an exit (from the zero interest policy).

No similar decision on exit is in sight in the euro area. But some have argued that the ECB should consider further easing measures (pushing the deposit rate deeper into negative territory or increasing the size of its asset purchase program). But should further easing measures be even discussed at this point? [...]

Central banks all over the world have chosen not to aim for absolute price stability, but rather for some increase in the price level of about 2%, because they fear the downward rigidity of wages. In a constantly changing economy, some prices need to go up, relative to the general prices, whereas others need to go down. These fluctuations around the average are easier to achieve when very few prices have to go down. The same applies to wages. It is easier to achieve relative wage adjustment when the average moves up slightly so that few wages have to fall in nominal terms. However, with oil prices falling, this argument loses much of its force since wages might be able to increase even if (consumer) prices do not. This is another reason why central banks should be less concerned about the persistence of low inflation.

Public finances should also benefit from the deflation or low inflation engendered by falling oil prices. Government revenues depend on the value of domestic production, i.e. GDP, and not only consumption. Lower oil prices depress consumer prices, but should boost production and GDP. Absent large price changes for raw materials, the consumption price index, which is usually used to measure inflation, evolves along with the price deflator for the entire economy (the GDP deflator). But this will not be the case this year since consumer prices are falling, but the GDP deflator (and nominal GDP) is still increasing. This should lead to solid government revenues, which is good news for highly-indebted governments throughout the industrialised world, but particularly for the euro-area periphery. [...]

The near-deflation fall in (consumer) prices, which the euro area is experiencing right now, should thus be seen as a positive development. The euro-area periphery in particular can look forward to an ideal combination of low interest rates, a favourable euro exchange rate and a boost to real incomes from cheap oil. Lower oil prices might make it more difficult for the European Central Bank to achieve its target of an inflation rate close to 2%, but in reality lower oil prices represent a boon for Europe and in particular for the beleaguered euro-area periphery.

Much of the impact of lower oil prices comes with a delay. This implies that the ECB might be mistaken even if it looks at (HICP) inflation for the medium term. When oil prices went up, the ECB chose to ‘look through’ the temporary impact, it should do the same now that oil prices continue to fall.

In practical terms this suggests that there might be no need for the ECB to prolong its asset purchase programme, even if inflation remains below 2% by end 2016.

Full commentary

© CEPS - Centre for European Policy Studies

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