Deflation and negative interest rates: why the ECB is worried!

Euro economies are heading for deflation, the ECB is alarmed, Mario Draghi is set to act.

Included in the arsenal to reverse the trend are cuts in interest rates (posibly even nagative interest rates). Good news for mortgage holders, bad news for savers.

Falling wages, lost jobs, high unemployment means that deflation has the ECB running for cover

But what is deflation and why do central bankers fear it so much?

Quite simply, deflation is an economic environment characterized by a steady decline of product and service prices.

From an Irish perspective, a first reaction may be, “So what?” or “Isn’t that a good thing?”.

Falling prices allow consumers purchase more goods and services with their income. Surely that can only be welcomed in an era of austerity. Right? Many retailers live and die on mottos of better value for money; Lidl, Aldi, Tesco…every little really does matter!

Even tourists we are keen to attract to our shores, surely a better value Ireland should mean more positive reviews online meaning more tourists come here, it’s a virtuous cycle, isn’t it?

The problem arises when too much of this “good thing” occurs.

Deflation gets its start when a recessionary economy causes consumers to pull back and scrutinize their purchases. In a demand-challenged environment, it is understandable for companies to offer “keep the lights on” discounts while fully intending to raise prices when times get better. The problem is that, given the combination of a slack economy, price-sensitive customers, aggressive discounting by rivals, and the inescapable equation that Price – Cost = Profit, the handiest ways for companies to improve profits are cutting wages, laying off workers, and/or squeezing supplier margins. Such cost-cutting actions result in even less money in the pockets of consumers, which results in fewer purchases and of course makes them more interested in discounts.

This is the crux of the problem for the ECB. Falling prices have resulted in lost incomes and lost jobs and the disparity across the Euro area is alarming. High unemployment is rampant.

If the ECB cuts interest rates in June, we should view it as a fire sale where the benefits will not reach everybody. Many banks across Ireland will not pass reductions, especially those with standard variable rate mortgages. Savers too are being hit and for those that do receive some reduction on their mortgage repayments, rising health insurance costs, rising transport costs, water charges and property taxes will neutralise any benefit.

Mr. Draghi should be very worried.




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