Deflation or stagflation in the Eurozone?

Sylvester Eijffinger 15 January 2009



Assessments of European price stability risks outright reversed in recent months.1 Until summer 2008, monetary policy was concerned with inflation pressures from surging commodity and energy prices. Last month, facing possible recession, the European Central Bank (ECB) cut interest rates by an unprecedented 75 basis points. Falling commodity prices and weak demand have eased inflation.

All major economic organisations found forecasting growth and inflation difficult and uncertain in 2008. While most observers expect both growth and inflation to significantly slow (i.e. a traditional recession), some argue that we are on the brink of deflation, while others argue that stagflation could be the true concern in the medium to long run. Obviously these views yield very different ECB policy recommendations. In this column, I argue that inflation is a far greater risk than deflation and urge policymakers to recognise the option value of waiting in changing interest rates.

The danger of deflation is exaggerated

Deflation previously captured significant attention during the last global recession. The 2003 deflation scare resulted from the belief that the negative output gap would push already-low rates of US (core) inflation into negative territory. This year, the Wall Street Journal, International Herald Tribune, and The Times mentioned the term deflation 50 times in the first 20 days of November, by the Economist’s count. There have been many more mentions since, although most stories were referring to the US, not the Eurozone.

Any deflation danger is far from imminent, according to the authorities. ECB President Jean-Claude Trichet and Executive Board Member Jürgen Stark have both indicated that the central bank does not see trends or signs of deflation arising in the Eurozone. The ECB is happy with the easing of inflation, as it will allow central banks to lower interest rates and governments to apply fiscal stimulus measures.

OECD Secretary General Angel Gurria did not rule out all risk of deflation, but he said that the OECD does not see any major deflation risk at present. Only some products and commodities have declining prices; there is no general price decline.

Similarly, European Commissioner Joaquin Almunia attributed the drop in prices to oil, commodities, and the recession. “We have a labour market that is organised in such a way that makes it extremely, extremely difficult to go towards deflation," he said. Presumably, he refers to the Eurozone’s higher degree of nominal and real wage rigidity, which is an important line of defence against deflation. The recession should be mitigated by fiscal and monetary stimuli, and Almunia foresees a return to growth in the second half of 2009.

We can even go further and say that the danger of deflation is exaggerated. Thomas Mayer (2008), Managing Director at the Global Economics division of Deutsche Bank, states that the future will bring very low growth in large industrialised economies and a long-term rise of inflation. He argues that, due to global imbalances, consumers in the large economies were no longer able to repay their debt. The government had to step in to take over bad debts to prevent mass bankruptcy and avoid deflation due to faltering demand. Additionally, monetary policy must be eased, as the US has and the Eurozone may be following. This should avoid a very deep recession and thus deflation and, given the amount of monetary stimulus, might lead to inflation instead in the medium to long run.

Empirical evidence on inflation and deflation risks

Kilian and Mangianelli (2007) have proposed formal, quantitative measures of deflation risks. They have assumed that the risk preference of the private sector with respect to inflation matters for the assessment of (excessive) inflation or deflation risks. Using data on inflation from 1960 to 2002, they have estimated the risks of deflation and inflation for the United States, Germany (as a proxy for the Eurozone), and Japan for horizons of up to two years using a sophisticated forecast model. Since deflation was also an issue in 2002, it is surprising that is the forecast suggests no evidence of substantial deflation risks for the United States or Germany. The authors do find evidence for substantial deflation risks in Japan. Figure 1 below illustrates their result. Deflation risks for the US and Germany were around zero for almost the entire period (the exceptions are 1987 and 2000, after the stock market crash), and they have never actually approached the deflation risks in Japan during the 1990s.

Figure 1. Excessive inflation risks and deflation risks: US, Germany, and Japan

Note: EIR denotes excessive inflation risks and DR denotes deflation risks.

Updating this model with data through November 2008, I find similar estimates of risks to price stability, reported in Table 1. Large (positive) inflation risk and large (negative) deflation risk are undesirable – the optimal balance of these risks is zero. I have taken the lower and upper bounds of acceptable inflation to be 0% and 2% respectively, corresponding to the ECB’s acceptable range.2

Table 1. Risks of inflation and deflation, November 2008

    One-year horizon Two-year horizon
Excessive inflation risk United States


  Germany 0.88 0.00
  Japan 0.41 0.23
Balance of risk United States 1.77 1.80
  Germany 0.88 0.20
  Japan 0.20 -0.55
Deflation risk United States 0.01 0.00
  Germany 0.01 0.20
  Japan -0.21 -0.78

The table shows that Kilian and Mangianelli’s conclusion still holds. All three countries face positive inflation risk, and only Japan faces a substantial deflation risk. The risk of deflation in the Eurozone and United States are almost negligible, particularly at the one-year horizon. There is no evidence of substantial deflation risks in Europe or the US. This conclusion is supported by current evidence on break-even inflation rates derived from inflation-linked bonds showing also a larger risk of negative inflation rates in the US than in the Eurozone.

Central bank policy in the Eurozone and the US

What should a central bank do to avoid deflation (and deflationary expectations)? If central bank decision-making is costly, then there is an option value of waiting for changing interest rates (Eijffinger, Schaling, and Verhagen 2007). It may be better for a central bank to wait and see if the economy moves to target inflation on its own.3 Moreover, acting too much to prevent deflation may lead the public to believe that deflation is a real danger.

The US Federal Reserve is much more active than the ECB in changing its interest rate. It may be risking these adverse consequences while exhausting its options by the time the recession really kicks in. The US is not in such a worse position to justify such activist behaviour. The ECB may wait to see whether oil and commodity price decreases are permanent or temporary and then act. Only permanent drops will necessitate further ECB action.

ECB Executive Board Member Bini Smaghi (2008) has explained the bank’s policies to avoid deflation. First, the ECB anchors expectations by a quantitative definition of price stability and transparency in decision-making. Second, it preventatively acts to reduce the probability of hitting zero interests rates, while exercising restraint so that it does not adversely affect market sentiments by acting too quickly. Moreover, a central bank should avoid exhausting its ammunition in pre-emptive actions. The ECB, with its rate of 2.5%, is better positioned to face a shock than the Fed, whose rate is near 0%.

Finally, too low interest rates can induce excessive risk taking, the main cause of the current crisis. Excessively low rates were an important factor at the beginning of the global credit crisis in the US subprime crisis. Unfortunately, there is a natural tendency to postpone tightening of interest rates in a period of recession until a solid recovery is taking place. The Fed was very quick to reduce its interest rate after the dot-com bubble, but it took years for the Fed to bring the interest rate back up. This is likely to be repeated. Indeed market participants now expect the Fed to bring the Federal Funds rate to 1.5 % only at the end of 2010. Raising interest rates contrary to investors’ expectations would disrupt capital markets, so the Fed is less likely to do so. Additionally, when interest rates have been low for a long time period, the central bank has to increase them more sharply to bring interest rates back in line with inflation expectations.

In the short run, the ECB has to act in an environment with major flaws in the financial system (dysfunctional money and credit markets) under a lot of macroeconomic uncertainty. Therefore, its monetary policy actions will not probably work as expected and the ECB’s option value of waiting will be high. In the medium term (the ECB’s policy horizon) the risk of excessive inflation is (much) higher than the risk of deflation. By the globalisation of monetary policy, it will be hard for the ECB to shield the Eurozone from the quantitative easing by the Fed and other central banks in the world.


Agence France Presse (2008), No Sign of Eurozone Deflation – ECB, 19 November.
Dow Jones (2008), “Trichet: Must mull Oil Price Effect on Deflation, Expansion,” 23 December.
The Economist (2008a), “The Deflation Index”, 20 November.
The Economist (2008b), “Depressing Times”, 13-11-2008
Eijffinger, S.C.W., Schaling, E., Verhagen (2007), W.H., “Interest Rate Stepping: Theory and Evidence,” Journal of Economic and Financial Sciences, vol.1(1) pp.67-93
European Central Bank (2008), Monthly Bulletin, December
European Commission (2008), Economic Forecast, Autumn
Kilian, Lutz and Simone Manganelli (2007), "Quantifying the Risk of Deflation," Journal of Money, Credit and Banking, vol. 39(2-3), pp. 561-590.
Mayer, Thomas (2008), “The Reports of Deflation Are Greatly Exaggerated¸” Wall Street Journal Europe, 8 December.
OECD (2008), OECD Economic Outlook No. 84, November
Reuters (2008a), “OECD Chief Does Not See Big Deflation Risk”, 15 December.
Reuters (2008b), “EU’s Almunia: Deflation Not Real Risk in Eurozone”, 3 December.
Smaghi, Lorenzo Bini (2008) Careful with (the D) words!, Speech at the European Colloquia Series, Venice, 25 November.
Thomson Financial (2008), “ECB’s Stark Sees Little Deflation Risk for Euro Zone”, 22-12-2008

1 The author gratefully acknowledges the very helpful comments of Hans Blommestein, Willem Verhagen and Edin Mujagic and the excellent research assistance of Rob Nijskens. This column is a short version of the Briefing Paper written for the Monetary Dialogue of January 2009 by the Committee on Economic and Monetary Affairs of the European Parliament with the President of the European Central Bank.
2 Kilian and Manganelli (2007) use the bounds 1 and 3.
3 In normal times central banks like to move gradually, but some central banks (e.g. Swedish Riksbank) have explicitly stated that this preference for gradualism is deemed inappropriate in extraordinary times.




Topics:  Monetary policy

Tags:  inflation, deflation, monetary decision-making, interest rate lower bound

Professor of Financial Economics at Tilburg University, President of the Tilburg University Society and CEPR Research Fellow


CEPR Policy Research