Greek Prime Minister Alexis Tsipras (L) arrives at a European Union leaders summit in Brussels February 12, 2015.POOL/Reuters
Cutting interest rates has become all the rage in Europe and a few central banks have dropped them into negative territory, signaling that deflation – falling prices – remains one of the top risks to the long-delayed economic recovery.
The other is Greece, which may or not be part of the 19-country euro zone by the summer if Greece's standoff with its international creditors persists. At the opening talks on Wednesday night in Brussels, both sides were so far apart that they couldn't even agree on a negotiations roadmap, though the European Central Bank was kind enough to inject another €5-billion ($7-billion) of liquidity into Greek banks.
Sweden on Thursday joined the expanding list of countries to embrace a negative interest-rate policy as falling inflation turns into outright deflation. The Swedish central bank, the Riksbank, cut its main interest rate to negative 0.1 per cent, a record low, from zero and also announced a small quantitative easing program. The European Central Bank and the central banks of Switzerland and Denmark have also imposed negative rates.
Negative rates encourage banks to lend out their money instead of stashing it at the central bank; a negative deposit rate acts as a fee. Quantitative easing, a form of money printing, injects cash into the economy (the ECB launched a €1.1-trillion QE program last month). The combination of the two is designed to ramp up economic activity and create consumer demand.
In Denmark, headline inflation has been negative for the better part of two years and falling oil prices – they are down about 50 per cent since June – have made central bankers nervous that a prolonged period of deflation could set in. Denmark, the ECB and other European central banks generally target inflation rates of close to, but not above, 2 per cent.
Central bankers distinguish between "good deflation" and "bad deflation," as Bank of England Governor Mark Carney noted on Thursday. Good deflation effectively raises disposable income, encouraging spending. Falling prices can also be the result of improved productivity – the output of goods and services at a lower cost.
But bad deflation is a potential economy wrecker. If prices keep falling, and consumers and businesses expect them to keep falling, the natural inclination is to stop buying today in the belief that the product or service on your shopping list will cheaper tomorrow, or a year from tomorrow. When consumers stop consuming, growth stalls or goes into reverse and jobs vanish.
While European central bankers, Mr. Carney among them, insist that prolonged deflation is highly unlikely, they are not taking any chances. The Bank of England made it clear that it no longer saw 0.5 per cent as the rock-bottom interest rate. At the same time, Mr. Carney seemed optimistic that moderate inflation would return fairly soon. "It's pretty clear in terms of our central expectation that the most likely next move in monetary policy is an increase in interest rates," he said.
The threat of deflation and the potential for Greece's exit from the euro zone – Grexit – are the biggest blots on the European economy. Of the two, Greece seems the greater threat, if only because the consequences of an exodus, if it happens, are anyone's guess.
The worst-case scenario would be the domino effect, in which the euro zone shatters as weak countries – Portugal, Spain, Italy – follow Greece out the door, leaving a trail of insolvent banks behind them. The benign scenario is a short-term shock that is largely limited to Greece itself. It is based on the theory that the European Union could withstand Grexit because the EU economy is no longer in recession and defence mechanisms – quantitative easing, bank liquidity programs and sovereign rescue funds – would work as shock absorbers.
Certainly, investors this week seem to be taking the optimist view in spite of the Greek standoff. On Thursday, the European and U.S. stock markets and the euro were up. The oil price rally continued, partly in the belief that stronger economies will push up demand and that the ECB's QE program will speed the European recovery. The sinking euro – a consequence of QE – will help exporters.
If Greece and its creditors broker a compromise that keeps Greece in the euro zone, and deflation proves to be short-lived, euro zone growth could surprise on the upside, as economists say. They are big ifs, but investors seem to be a lot less scared than they were even a couple of months ago.