Why is eurozone inflation so persistently low?

6th March 2016, Comments 0 comments

Despite a raft of different measures by the European Central Bank to kickstart sluggish consumer prices in the eurozone, inflation in the single currency bloc turned negative in February for the first time in five months.

The ECB estimates that consumer prices need to rise at an annual rate of close to but just below 2.0 percent to foster healthy economic growth. But area-wide inflation stood at minus 0.2 percent in February, due to the combination of a number of different factors, experts say.

- Oil -

"The low level of inflation and the drop in February are largely attributable to energy price developments," Oxford Economics economist Ben May told AFP.

Oil prices have been falling sharply for the past two years, weighed down by over-abundant global supply.

For households and businesses, this may be positive, as it cuts energy bills, reduces heating costs and expenditure on petrol. But given the heavy weighting of energy prices in the overall basket of goods that are used to calculate consumer prices, they are keeping a lid on the headline rate of inflation, May said.

The oil market, which hit its lowest level since 2003 at the beginning of this year before tentatively picking up at the start of February, has seen strong fluctuations in recent weeks amid speculation supplier countries may throttle production.

Nevertheless, a substantial and sustained rebound in oil prices does not seem to be on the horizon for now. As a result, inflation forecasts for the euro area look set to be downgraded again, said Bundesbank president Jens Weidmann recently.

- Exchange rate -

After falling sharply in March 2015 in the wake of the ECB's announcement of a massive asset purchase programme known as QE, the euro has risen against the dollar since and is currently hovering at around $1.10.

"A rise in the euro exchange rate means that the price of imported goods falls," said May.

In other words, if the euro rises in value against other currencies, the price of an imported car or refrigerator is reduced, bringing down the overall inflation rate.

- Wages -

Another factor weighing on inflation are wages.

"A lot of the countries affected by the crisis, such as Spain, Portugal and Greece, have been forced to reform their labour markets and make them more flexible, which has led to lower wages," said Natixis economist Johannes Gareis.

That leads to lower household spending which, in turn, leads to lower inflation.

At the same time, the weak inflation outlook in the coming years has an impact on wage negotiations and puts a brake on wage increases, analysts argue.

"With zero or even negative inflation, households' purchasing power increases, which relieves the pressure on the part of employees and unions for higher pay increases. The weak inflation outlook keeps a lid on wage demands," said Charles Wyplosz, economics professor at the Graduate Institute of International and Development Studies in Geneva.

- Sluggish investment -

Sluggish corporate investment is another factor.

When companies invest, they create jobs, which can push up salaries, and consequently inflation.

But "lots of companies are worried about the future," said Wyplosz.

"Financial market concerns aren't helping things," he said. "Companies are not sure whether the upturn will last or is fundamentally strong.

"Companies see sluggish recovery and are reluctant to make any sizeable investment," Wyplosz said.

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© 2016 AFP

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