The euro zone is heading for deflation

This is Daily Telegraph’s Ambrose Evans-Pritchard quoting me on the risk of deflation in the euro zone:

“Europe is heading into a deflationary scenario if they don’t do anything to boost the money supply,” said Lars Christensen… “This already looks very similar to what happened in Japan in 1996 and 1997.”

If you don’t already realise why I am talking about the risk of deflation then you just have to remember the equation of exchange – MV=PY.

We can rewrite the equation of exchange in growth rates and rearrange it. That gives us the the following model for medium-term inflation:

(1) m + v = p + y


(1)’ p = m + v – y

If we assume that money-velocity (v) drops by 2.5% y/y (the historical average) and trend real GDP growth is 2% (also more or less the historical average) and use 3% as the present rate of M3 growth then we get the follow ‘forecast’ for euro zone inflation:

(1)’ p = 3 % + -2.5% – 2% = -1.5%

So the message from the equation of exchange is clear – we are closer to 2% deflation than 2% inflation.

Yes, the world is much more complicated than this, but I believe this is a pretty good illustration of the deflationary risks in the euro zone.

We still don’t have outright deflation in the euro zone, but we are certainly getting closer – and inflation is certainly well below the ECB’s 2% inflation target. The graph below clearly shows that.

GDP deflator inflation euro zone

So effectively the ECB has been undershooting it’s 2% inflation target since 2008 – at least if we use the GDP deflator rather than ECB’s preferred measure of inflation (HICP). See my earlier post on why the GDP deflator is a much better indicator of monetary inflation than HICP here.

The reason for these deflationary tendencies is obvious – overly tight monetary policy.

Just have a look at this graph – it is the level M3 versus a hypothetical 6.5% growth path for M3. (If you read this blog post you will see why I use 6.5% as a benchmark)

M3 eurozone

This is why I talk about the need to “boost” money supply growth. The ECB either needs to increase velocity growth (the fed and the BoJ is likely helping a bit on that at the moment) or money supply growth otherwise the euro zone is heading for deflation. It is pretty simple.


Related posts:
Failed monetary policy – the one graph version
Failed monetary policy – (another) one graph version
Friedman’s Japanese lessons for the ECB

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