The latest euro area monthly inflation numbers are out and manage to give cause for both gloom and cheer. First the bad news: inflation is too low.
The euro area average figure of just 1.1% is a cause for concern because it is so low – only a little over half what the ECB (rightly) considers compatible with its goal of maintaining price stability. Moreover, it has been falling rather continuously over the year. This is no surprise given high and rising unemployment and the huge amount of slack in the economy. If circumstances were different – a “normal” downturn – below-target inflation might be good news, in that it signals that the central bank or fiscal policymakers have scope to loosen policy. But in the current context of a liquidity trap and with austerity certain to continue, albeit in milder form, it is worrying. It implies low pricing power for firms, and thus limited incentive to invest, virtually no disincentive to postpone purchases and, not least, very slow erosion of the real value of outstanding debt.
There is some good news, though. If the overall level is low, the distribution of inflation rates across the euro area is, broadly, as it needs to be to bring about the necessary rebalancing. In the graph below I have plotted the latest inflation rate of the euro area countries (in each case minus 1.1%, the euro area average) on the x-axis against the current account position (as a % of GDP in 2012) on the y-axis.
The picture is very clear – and encouraging. By and large, those countries with the largest deficits have the highest rates of relative disinflation; their relative competitive position is improving. Countries with surpluses have above-average inflation and are thus, given a common currency, losing relative competitiveness. It is worth noting that, at least according to this simple metric, relative inflation in Germany and the Netherlands, and also Ireland, should be considerably higher given their competitive position; the opposite applies notably to Estonia, but also Finland, Greece and Cyprus. But because the average is so low, relative disinflation in Greece, notably, actually means absolute deflation, poison for recovery.
Put together the two findings – overall level too low, distribution broadly correct -, throw in for good measure the fact that the euro area as a whole is inexorably moving into trade surplus, and the policy implication is clear: expansionary (and thus inflationary) policies in the core countries with large current account deficits.
Yes, my German and Dutch friends, I am looking at you.