Deflation and the debt sustainability dilemma

Deflation is the problem the ECB is least able to cope with. The central bank is making its predicament worse by focusing on inflation expectations, which are sticky. This will not guide prices back to the ‘close to but not above’ 2% target. Its own inflation forecasts illuminate part of these risks but accelerated deleveraging triggered by the asset quality review (AQR) and an appreciating euro make the story all the more troublesome. The backdrop of falling inflation/deflation is critical for the periphery where real GDP growth is struggling to move back above zero. Falling prices and the resulting stagnation or decline of nominal GDP will place renewed pressure on debt sustainability and make competitiveness gains even harder to achieve. Reflation via euro devaluation looks the only realistic solution, or exit from the currency union should return to the options table. Both roads point to a weaker euro.

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