How significant are the deflation risks in the eurozone?

The steep decline in eurozone inflation has prompted deflation concerns. Although we think it most likely that inflation will head back up towards 2% in the medium term, we have to investigate the drivers for more adverse deflationary or indeed inflationary scenarios. 

In our latest Working Paper "How significant are the deflation risks in the eurozone?" we establish that the range of possible price trends over the medium-term horizon is broad. In 2016 these range from -0.4% to 3.3%. In the base scenario of a moderate economic upswing, our model-based projection shows a gradual pickup in the inflation rate. In 2014 it comes in at around 1.2%, in 2015 around 1.6% and in 2016 around 2.0%.

Following the meeting of the Governing Council on 06 March the European Central Bank will be publishing its staff projections for inflation for the year 2016 for the first time. Obviously, the medium-term inflation outlook is of pivotal importance for the ECB’s policy going forward.In this context, it is important to bear in mind that the ECB projections have a signal function and are not designed as risk scenarios. This alone would lead us to expect that the ECB will not be publishing too wide a margin, as this would suggest considerable uncertainty about the inflation outlook.

But the financial market investor needs to be aware of these uncertainties. Inflation has a major impact on financial market trends and most important implications for investment decisions. It can be assumed that both the inflation scenario as well as the deflation scenario will jolt the markets. The deflation scenario would probably lead to a significant setback for the stock markets. In the inflation scenario, we would still expect to see a positive development, which is based on a significant economic recovery, initially. Bonds would lose quite dramatically. In both scenarios, however, there are self-correcting mechanisms and policy reactions to be taken into account. In the inflation scenario the ECB would react by significantly raising interest rates. In the deflation scenario far-reaching unconventional monetary policy measures would be on the cards, and fiscal policy would most likely attempt to stimulate the economy. In both cases, these measures could lead to a turning point on the stock markets. This means that both risk scenarios present financial market investors with the very significant challenge of timing things correctly. It goes without saying that deflationary trends would put a stop to any normalization of both short-term and long-term interest rates. Due to the ongoing investment drought, and the difficulties faced by economic policy in combating it, the deflation scenario would probably have more serious consequences than the inflation scenario.

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