Wishful Thinking At The European Central Bank

by: Desmond Lachman

One has to be dismayed at the ECB's continued ability to convince itself that there is absolutely no risk of deflation in Europe despite the mounting evidence to the contrary. Such deflation denial runs the risk of delaying the adoption of further unorthodox monetary policy measures, which might have offered some hope of staving off a prolonged period of Europe-wide deflation. This has to be particularly regretted since deflation would be very damaging to the highly indebted countries of the European periphery.

In its latest monthly bulletin, the ECB stridently asserts that "the risk of deflation in the euro area appears remote at the current juncture." It justifies this assertion in part by looking backwards and in part by referring to its own economic forecast. It suggests that currently the share of items with falling prices is not particularly high and inflation expectations remain well anchored. Surprisingly, it also supports its assertion by tautologically referring to the ECB's own forecast that growth will somehow pick up and inflation will accelerate over the next two years.

The weakness of the ECB's inflation analysis is that it does not pay attention to forward-looking indicators. Those indicators have to raise questions about the ECB's current confidence about Europe's inflation outlook. Among those forward indicators are the very large gaps that currently characterize the European labor and product markets and that the ECB itself expects to persist over the next two years. One would have thought that the ECB might have inferred that in the same way that large gaps caused European core inflation to decelerate over the last year from 1.2% to 0.7%, the maintenance of unemployment at more than 11¼% over the next two years, as the ECB is now projecting, would cause inflation to decelerate further in the period immediately ahead.

Another forward looking indicator at which the ECB should have been looking is its own money and credit supply data. Those data reveal that bank credit to the private sector is continuing to decline at around a 2% annualized rate while overall European money supply growth continues to expand at less than half the ECB's desired 4.5% rate. This is hardly consistent with a reacceleration of inflation anytime soon. At the same time, contrary to what the ECB is asserting, inflationary expectations as measured by consumer surveys and by short-term financial market interest rates are now showing a disturbing downward trend.

Over the past two years, the ECB's economic forecasts have consistently over-estimated both the pace of economic recovery and inflation. Judging by its latest monthly bulletin, the ECB seems to have learnt little from its past forecasting errors. Since despite all the clues to the contrary, the ECB still clings to its wishful thinking that somehow inflation will pick up even in the context of continued very high labor and product market gaps.

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