Euro zone Deflation and ECB action By Dr. Bobby Srinivasan and Dr. Sudhakar Balachandran

While the Indian government is currently battling high inflation rate, the euro zone countries are slowly and steadily sinking into a Japanese style deflation. The RBI of India recently announced that there is no change in the repo rate but lowered the SLR by 50 basis points. Mr. Mario Draghi, President, ECB on the other hand chose to cut their key interest rates below zero. This is an unusual step and he becomes the first central banker to do so.

Mr. Draghi announced, besides the cut in the interest rate, a package of up to Euro 400 bln of cheap loans in an attempt to boost lending to the regions credit starved small businesses. If the impact of this policy is adequate, Mr. Draghi has said that he will consider some quantitative easing.

The euro currency initially didn’t like this announcement. It dropped from 1.3650 to 1.35 to a dollar but ended the day back to the original level. None of the US Federal Reserve, Bank of Japan or Bank of England has attempted this.

The ECB is counting on lifting the inflation up by weakening the euro and spurring lending. This bold action by the ECB may not necessarily push the demand for goods and services. Given the present high rate of unemployment in the euro zone pushing down the interest rate alone will not work. Job creation on the other hand will do wonders for the economy. But this interest rate cut was done to bring cheers to the market which it did. Keeping money in the bank is a no no. The deposit rate dropped from 0.25 percent to minus 0.1 percent. Bankers who park their cash at the central bank have to pay a fee. Strange isn’t it.

The forecasters are bullish about the future growth prospects. They expect 0.7 percent growth for 2014, 1.1 percent for 2015 and 1.4 percent for 2016. Let us hope their predictions come true.

Of particular concern is the low rate of inflation, currently around 0.5 percent. This increases the danger of Japanese style deflationary spiral. Besides there are limits to what monetary policy can do; Will Draghi’s approach work? We will wait and see.

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