The timing could hardly have been more opportune: just days before its next policy meeting, the European Central Bank (ECB)has been provided with evidence that deflation edges ever closer. The annual inflation rate in March across the 18-nation eurozone dropped to 0.5%, its lowest level in over four years. Five countries are already seeing prices drop year on year.
Faced with the same data, the response of the US Federal Reserve or the Bank of England would not be in doubt: policy would be eased. But this is the ECB we are talking about, so the financial markets are in two minds as to what will be decided on Thursday.
Initially, the euro fell on expectations that the ECB would be forced to act. But then the markets had second thoughts, noting that the president of the Bundesbank, Jens Weidmann, had commented at the weekend that the growth picture was improving and that inflation was being driven lower by temporary factors.
The suspicion that the ECB will sit on its hands led to the euro rising against the dollar, the pound and the yen.
The ECB needs to be extremely careful that it does not sleepwalk its way to disaster. The short-term threat of deflation may well be exaggerated by the timing of Easter in 2013 and 2014. It may also be the case that falling inflation is boosting real consumer incomes by making pay packets go further.
But growth is weak, banks are reducing their lending, credit is contracting, and the ECB is reducing the size of its balance sheet.
To cap it all, the euro has been strengthening at a time when a key export market – China – has been slowing.
Sure, in the best of all worlds, the eurozone recovery will continue to strengthen. But the risk of growth losing momentum – as it did in the UK in 2011 and 2012, before the announcement of the Funding for Lending scheme – is real. The eurozone is one mild recession away from being the new Japan. Hence the need for policy action. Starting this week.
