The professor of passivity: three lessons for Mario Draghi.

AuthorLachman, Desmond

History is bound to judge harshly the European Central Bank's current maintenance of a passive monetary policy stance in the face of markedly decelerating inflation. This is more so the case since the ECB is maintaining this stance despite the fact that eurozone inflation is now running at less than half of the ECB's inflation target. It is also doing so despite the fact that European unemployment remains at record-high levels and Europe remains in the grip of a crippling credit crunch.

While low inflation levels by historic standards characterize most of the world's advanced economies, the eurozone stands out as the economic area where inflation has been decelerating at the fastest pace and where inflation is now at the lowest level of the world's major economies. Over the past two years, eurozone inflation, excluding volatile items like food and energy, has declined by around one-half from 1.5 percent to 0.8 percent. This takes eurozone core inflation to its lowest level in the euro's fifteen-year history and to less than half the ECB's inflation target of "below but close to 2 percent." It also puts inflation into what economists generally consider to be the danger zone, which necessitates resorting to aggressive policy action to forestall the risk of outright deflation.

A particularly troubling aspect of recent eurozone inflation performance has been the marked divergence of inflation performance between the zone's northern and southern member countries. While inflation in the more buoyant Austrian, Dutch, Finnish, and German economies has been not very far below the ECB's inflation target, the same is hardly true of the countries in Europe's troubled economic periphery. Indeed, Cyprus and Greece are now experiencing outright deflation, while Ireland, Portugal, and Spain are all on the cusp of deflation. Regretfully, these countries are the ones most in need of higher inflation to help them cope with their very heavy public and private sector debt burdens.

The deflation risk associated with European inflation falling into the danger zone has not escaped IMF Managing Director Christine Lagarde's notice. In recent weeks, she has called on the ECB to be much more proactive in its policies to avoid the risk of deflation. However, Madame Lagarde's concerns are not shared by ECB President Mario Draghi. Indeed, he has been stridently dismissive of any notion that Europe might be on its way to experiencing anything like Japan's deflation over...

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