Inflation and interest rates indicate urgent need for action

José Manuel Barroso, President of the European Commission, received Enrico Letta, Italian Prime Minister. During the press conference the President highlighted that the launch of this new phase in Italian politics and the start of work by the new government came at a crucial time for European integration. (EC Audiovisual Services, 02/05/2013).

José Manuel Barroso, President of the European Commission, received Enrico Letta, Italian Prime Minister. During the press conference the President highlighted that the launch of this new phase in Italian politics and the start of work by the new government came at a crucial time for European integration. (EC Audiovisual Services, 02/05/2013).

Inflation indices are a measure not only of the rate of change of consumer prices. In organised economies like Eurozone inflation is a good indirect measurement of economic activities. A bit more inflation above the benchmark of 2% is a good indication that the economy is growing, the opposite for measurements below that level. Inflation changes are usually slow and economic entities like the Eurozone do not produce abrupt variations. Rates close to 1% are considered as indications of disinflation and general economic stagnation.

Based on data for April this little theory gives alarming conclusions. Eurostat, the EU’s statistical service, announced its flash estimate for April inflation at 1.2% after the 1.7% in March. This was an abrupt drop bringing the rate close to 1%. It was also an unusually large fall of the rate of change of consumer prices, signifying a bad turn in consumer markets and constituting an indication that the economy has entered the zone of disinflation and recession. The Japanese economy suffers for many years now exactly of the same illness, with inflation measurements below 1%.

Inflation

Such large changes of inflation rates up to now were usually attributed to sadden and large changes of energy cost. In April however no abrupt changes in energy prices were evident. This becomes clear from Eurostat’s announcement where it is shown that all-items inflation excluding, energy, food, alcohol & tobacco fell from 1.5% in March to just 1% in April. This is core inflation containing mainly services, the largest component, accounting for around 42.3 % of individual consumption expenditure in the euro area. It is followed by non-energy industrial goods with around 27.4 %.

Unfortunately this is not the only indication that Eurozone is heading fast to disinflation and recession. Unemployment rates have skyrocketed mainly in the peripheral southern countries of euro area. In view of all that the Governing Council of the European Central Bank which is exceptionally meeting in Bratislava, Slovakia is expected to decide about the main interest rates of the bank. The current wisdom wants that the Council will reduce the main ECB interest rate from its current level of 0.75% to ½ a percentage unit.

Interest rates

Theoretically every time inflation falls markedly, central banks reduce their interest rates in order to help the economy with cheaper money to regain a growth path. In the present conjuncture however a quarter unit reduction of ECB’s main refinancing operations rate will have almost zero effects on the real economy. The reason is the deep fragmentation of Eurozone’s financial market.

In more than half of member state markets and in all southern countries, there is a real financial drought. No new loans are granted to households and the business sector and when they do the cost is dear. The problem there it’s not some decimal points of interest rates but the almost complete backstop in loans. Obviously the solution in Italy, Greece, Spain, Portugal, Ireland, Slovenia and elsewhere in Eurozone, cannot be a quarter percentage unit cut of ECB’s main interest rate. It’s got to be a complete re-enactment of the financial market, through the creation of the Banking Union.

This is what the new Italian Prime Minister said to the German Chancellor Angela Merkel, the French President Francois Hollande and the European Commission President Manuel Barroso while meeting them during the first three days in office.

 

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