Fears of Deflation for The Eurozone Loom Large as The Price Rise Falls Close to Zero

Eurozone, the union of 19 European Union member countries that use euro as a common currency, might enter into a deflationary zone with its annual inflation rate down to a mere 0.1 percent for May 2020, lowest seen in the past four year period. It was at 0.3 percent in April this year and had been sliding down with the falling oil prices as the main trigger.

Looking at the 4 major components of Eurozone annual inflation for the month, food inflation was at 3.3 percent, inflation in services stood at 1.3 percent, inflation in non-energy industrial goods at 0.2 percent and energy inflation at a negative value of minus 12 percent. Though, energy carries the lowest weight of 9.8 percent in the eurozone inflation basket.

For 12 out of 19 member countries, the monthly inflation figure for May was below zero. The Eurozone rate of inflation has been continuously going down since January 2020, the beginning of the year itself, when it was recorded at the year’s highest level of 1.4 percent.

When the prices of good and services go down, or the inflation slips to the negative zone, we have deflation. Deflation generates a vicious cycle as along with falling prices, the business profits also reduce, which then translates into a rise in unemployment. This leads to low consumer spending, thereby pulling down the overall demand for goods and services across the Eurozone economy. This has a spiral effect and puts additional downward pressure on prices or deflation. This could lead to a further economic slump.

Nation wise, Italy, the third-largest economy of the zone, after Germany and France, is one of the worst affected members in the Eurozone area, as coronavirus has hit the nation hard. With more than 2.3 lakh confirmed cases of corona and 33,229 deaths across Italy on May 30 this year, the country is striving to its best capacity to sail through the economic recession.

The annual rate of inflation for the month of May 2020 has fallen by 0.2 percent in Italy, making it slip in the deflationary territory, based on Italian EU-harmonized consumer price estimates. This decline in prices was also triggered by a sharp fall in energy costs, by an annual inflation value of close to minus 4 percent.

The country’s Gross Domestic Product (GDP) has fallen by 5.3 percent during the first quarter of 2020 (January to March) as compared to Q4 2019. It is projected to contract by 9.5 percent for 2020, based on estimates from the European Commission.

Eurozone economy under stress with rising government debt

The eurozone banks have raised their private sector lending by a massive amount of €73 billion in April this year, primarily to boost the economic activities. The total government debt for the 19-member zone is likely to shoot-up from 86 percent of the collective Eurozone-GDP in 2019 to more than 100 percent in 2020, according to the European Central Bank (ECB) estimates. (ECB is the central bank for the Eurozone and manages the region’s financial blueprint). This high level of debt has the possibility of becoming unsustainable if the economy does not show signs of early recovery.

For a commoner, it may seem that a high debt is not so much of an issue in a deflationary economy. But it is an area of grave concern. Though the real value of the debt will fall with deflation, there is a problem with the timely recovery of this debt, if the economic crisis continues and investment does not pick-up with demand remaining low.

Meanwhile, Christine Lagarde, President of the ECB has stated that the GDP of the Eurozone may shrink by up to 12 percent for the year 2020 due to the coronavirus pandemic.

So what steps is the ECB taking?

The central bank has already got a Pandemic Emergency Purchase Program (PEPP) in place, which is sized at asset purchases worth 750 billion euros. This program was rolled out in March this year.

With a sharp Eurozone economic contraction on the anvil, the European Central Bank is planning to pump more money into the system and will take a call on the same on June 4, in its Governing Council Meeting. It is likely to expand its emergency purchase plan by 500 billion euros if we go by the predictions by various experts and economists. It may also raise its share of supranational debt securities from 10% of public bond purchases at present. This is in line with ECB’s continued commitment to soaking up a sizeable portion of the Eurozone member-nations’ debt.

The ECB will be using all the instruments available at its disposal so that each and every sector of the Eurozone economy can gain from the trying financing turmoil, added its Governing Council member Mr. Ignazio Visco.

The bank is also holding firm its interest rates in the negative territory at -0.4 percent till at least the end of 2020, to stimulate private sector borrowings across the zone.

Impact on the Eurozone equity stocks

Till now, any direct impact of the Eurozone’s deflationary tendencies is not visible on the equity markets, as far as the top stock indices are concerned.

The Euro Stoxx 50 index, which covers the best 50 blue-chip stocks from the Eurozone region showed a daily downward movement of 1.43 percent to reach a level of SX5E 3050 on May 29, 2020. In the recent past, it touched a lowest level of SX5E 2386 on March 23 this year, after which it has been steadily moving up. Few prominent companies in the Euro Stoxx index whose movement would be interesting to watch to gauge the impact of deflation are Adidas, Bayer, Daimler AG, Linde plc, Nokia, Philips, Siemens, TOTAL SA, Unilever and Volkswagen Group.

It’s a bit early to predict if the fears of Eurozone deflation turn out to be true. On its part, the ECB is trying its level best to lift the economy and announce an emergency purchase plan within a week to help its member nations. But with government debt soaring for the region to record-high levels, the possibility of repayment of this debt will largely depend on the eradication speed of the COVID-19 pandemic and restart of businesses.