Last week, the European Central Bank (ECB) decided to keep its policy interest rates unchanged and to eschew resort to additional unorthodox monetary policy measures. It did so despite the clearest of evidence that inflation is decelerating in Europe as a whole and that a number of countries in the European periphery are now experiencing outright price and wage deflation. It also did so despite the fact that the ECB itself forecasts that large labor and product market gaps will continue to characterize the European economy in 2015. This has to raise fundamental questions as to whether the ECB is now not making the same sort of policy mistakes repeatedly made by the Bank of Japan over the past 15 years of doing too little too late to fight deflation.
The ECB's relative monetary policy passivity to avert the risk of deflation would seem to be based on its flawed macroeconomic forecast. The ECB anticipates only a sluggish European economic recovery over the next two years that will keep unemployment little changed from its present record level of around 12%. Yet, despite forecasting the persistence of very large labor and product market gaps, the ECB is forecasting that European inflation will somehow pick up over the next two years from its present level of 0.9% to 1.3% by 2014.
There would seem to be two basic reasons to question the ECB's seeming belief that high unemployment over the next two years will not lead to a further deceleration in European inflation towards deflation territory. The first is that over the past year Europe as a whole experienced a marked deceleration in inflation from 2.5% to 0.9% as unemployment rose to a record 12.2%. If high unemployment was associated with such a sharp moderation in inflation in 2013, one must ask why the same will not happen over the next two years as unemployment remains at an extraordinarily high level.
The second reason for doubting the ECB's seeming belief that high unemployment is not associated with decelerating inflation is the disparate inflation experience of individual Euro member countries. In countries like Austria, Finland, Germany, and the Netherlands, with very low unemployment levels, inflation is now running at between 1 ½ to 2%. Meanwhile in countries like Greece, Ireland, Portugal, and Spain with very high unemployment levels, wage and price deflation is now becoming the order of the day.
Two considerations make the ECB's present monetary policy passivity all the more difficult to understand at this juncture. The first is that under its own forecast inflation will still be only 1.3% in 2015 or significantly below the ECB's inflation target of close to but below 2%. The second is that the ECB itself repeatedly tells us that monetary policy operates with long lags. One would have thought that this recognition would have sensitized the ECB to the dangers of falling behind the policy curve in its battle with deflation.