The ECB Will Only Exacerbate Upcoming Deflation By Fighting The Wrong War

The Business Insider ^ | 5-21-2010 | Vincent Fernando, CFA

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The ECB Will Only Exacerbate Upcoming Deflation By Fighting The Wrong War

Vincent Fernando, CFA
May 31, 2010, 7:36 AM

While ECB president Jean-Claude Trichet remains concerned about maintaining his inflation-fighting credentials by, there are some who believe he's fighting the wrong battle.

The ECB has been buying government bonds in a bid to bring down European sovereigns' interest rates, but in order to 'mop up' the liquidity this creates, the central bank has been taking short-term deposits from banks in an equal and countervailing amount.

This has meant that the net new liquidity from these measures has been zero, in a bid to prevent inflation from rising.

Problem is, there are many who believe deflation is the larger risk right now for Europe, thus the ECB's actions to prevent inflation could actually be making things worse. Already, deflationary forces have shown up in some of the data. Ireland's price index fell in April and inflation was below 1% for five other Eurozone nations as highlighted by the New York Times. We highlighted other signs of deflation back in early March as well.

Moreover, austerity measures and wage reforms aimed at fixing broken European budgets will be highly deflationary.

The ECB faces the challenge of choosing the correct front to fight on. Should they defend against deflationary forces coming from weak European periphery economies? Or should they be worried about the inflation risks created by European stimulus efforts plus faster-growing economies such as Germany and France?

Given that Europe is faced with a debt crisis, perhaps battling deflation should take priority, since if deflation takes hold it will make sovereign debt burdens even more difficult to manage.

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