Persisting Disinflation in the Euro Area

The end of last week saw inflation data in the Euro area further pointing to the downside. If disinflation (falling inflation) continues for the period ahead, deflation threatens to grip the Euro economies. Despite massive easing from the ECB, spending does not catch up with the speed of capital creation. 

Such conditions normally lead to hyperinflation, only this time is different. For inflation, wages must be on the rise too, but what we see in the Euro area and some other developed regions is the lowest wage increase in modern history.

Negative Velocity of Money

The issue is not that there is no money, but that it is not being  put at work. The velocity of money, which is in a falling trend for the last twenty-three years, is currently crashing. When this happens, inflation has little chances to resurface as the money supply does not find its way in purchases of goods and services.

Last week revealed one of the most spectacular charts showing what households do. The French households’ savings ratio jumped 4.5% in the post-COVID-19 recovery, a staggering increase by all metrics.

At the same time, the public deficit widened to -4.8% of GDP in Q1, with expectations for the deficit to continue in the same direction. The huge gap between spending and savings threatens to push the Euro area inflation below zero, making it increasingly difficult for the ECB to meet its 2% inflation target.

Talking about the ECB, on Thursday, it is expected to announce its interest rate decision. It will have no other choice but to acknowledge the massive increase in bank loans/credit lines to Euro area corporates, a positive signal that the corporate world takes advantage of the ultra-cheap conditions provided by the ECB.

While a positive development for the Euro area, if not backed up by a rise in consumption, deflationary risks will increase. Money printing alone would not bring growth and inflation, indicating that somewhere there is a liquidity trap.

If we add to this mix the oil prices that declined overall in the last months, we notice a further negative effect on long-term inflation expectations as falling energy prices are a significant drag on headline inflation.

Little or no economic activity leads to significant negative demand pull, which would force prices to decline mostly. By definition, declining prices on a higher savings rate equal deflation.

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