Eurozone inflation fell steadily in 2013 and 2014, reaching negative territory at the end of 2014 – year-on-year inflation was ‐0.2% in December and core inflation hit the historical low at 0.7% in the same month (Figure 1). Inflation fell to historically low levels not only in the countries that had been severely affected by the sovereign debt crisis, but also in those less directly influenced (Figure 2). In December 2014, no country of the Eurozone registered an inflation rate above 1%; in 12 countries out of 18 (Lithuania joined 1 January 2015) consumer price dynamics were negative. Formal econometric analysis confirms that these developments reflected mostly common rather than country-specific shocks (Delle Monache et al 2015).
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Disinflation and deflation are a source of special concern, as the macroeconomic effects of positive and negative shocks to inflation are likely to be asymmetric. Due to the presence of constraints in the economy – namely the zero lower bound (ZLB) on nominal interest rates, borrowing limits, and downward nominal wage rigidity – the costs of disinflation and, a fortiori, deflation tend to exceed those of inflation. As inflation declines, those constraints become binding [...]
The role of aggregate demand and oil prices
The fall in inflation since early 2013 can only be partially attributed to the developments in prices of energy goods and unprocessed food. [...] This assessment is supported by Conti et al (2015) who find that the joint contribution of (conventional) monetary and demand shocks is at least as important as that of oil price developments (Figure 3). As regards the former, the effective lower bound to policy rates has prevented the ECB from providing the necessary monetary accommodation in the context of weakening prospects for economic activity and price dynamics. Falling inflation expectations have thus resulted in an unwarranted tightening of monetary conditions, as real rates have risen at a time in which aggregate demand was weak and inflation was already falling to low levels.
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The risk of de-anchoring of expectations
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The persistent decline of inflation expectations has raised concerns about the possibility of de-anchoring from the definition of price stability. Such concerns have been voiced by several members of the Governing Council of the ECB (see, e.g., Draghi 2014 and Visco 2014). Since mid-2014 negative tail events affecting short-term inflation expectations have been increasingly channelled onto long-term ones, igniting both downward revisions in expectations and upward changes in uncertainty (Figure 5). In contrast, positive short-term tail events have left long-term moments mostly unaffected (Cecchetti et al 2015). This asymmetric behaviour suggests that in the second-half of 2014 the risk of de-anchoring of long-term inflation expectations became material. This risk can be particularly serious in a context in which agents have incomplete information about the working of the economy and form expectations through an adaptive learning process (Busetti et al 2014).
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Conclusions
The decisions of the Governing Council of the ECB in 2014 and 2015 hinged on growing evidence that the weakness of aggregate demand was contributing significantly to the decline in inflation and that the anchoring of expectations to the definition of price stability was at serious risk. Several analyses carried out by Banca d’Italia confirmed this view.
The extraordinary measures adopted by the ECB will contribute to preserving the credibility of monetary policy – the most important asset of a central bank, and a necessary condition for maintaining price stability over the medium-term. The purchase of government bonds will support aggregate demand through a variety of channels, helping to bring inflation back to levels consistent with the definition of price stability (Cova and Ferrero 2015); the improved economic conditions will also allow indebted households to reduce their debt and loosen their financial constraint (Burlon et al 2015).
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