With the European Central Bank (ECB) finally recognizing that the euro area is battling against severe deflationary headwinds, further policy easing looks likely. This should help anchor bond yields, but may not be enough to overcome the huge challenges facing the region.
Our analysis finds worrying parallels between the euro area and Japan—the only country that has experienced true deflation since the middle of the last century—in a number of areas associated with the latter’s “lost decade.” This underscores the need for additional policy action from the ECB.
Whether or not the euro area actually experiences a period of declining prices is now a moot point in our view. To the extent that a deflationary environment can be characterized by weak nominal growth, upward pressure on debt ratios and very low interest rates, the euro area is already halfway there. We examine the implications of this for the region and argue that deflationary forces would play out very differently from the way they have done in Japan.