As prices in the eurozone continue to fall, the European Central Bank (ECB) is running out of tools to stave off the threat of deflation. It has already dropped interest rates into negative territory and it continues to buy government and corporate debt to keep yields down. Caught in the middle of the ECB’s battle with deflation are the people who are counting on their savings to get them through the troubled European economy.
What Exactly is Deflation?
Deflation is a macroeconomic condition characterized by declining prices. To people who have experienced periods of high inflation, it might seem that a period of deflation would be a good thing. While inflation erodes future purchasing power, deflation can have the effect of increasing it. Products can become cheaper and people’s money can go further. The problem is, during an extended period of deflation, companies are forced to reduce prices, which eventually reduces their profits. A deflationary environment is symptomatic of a slowing economy or a negative growth economy.
As companies cut back on production costs, they may be forced to reduce wages or lay off workers. Lower wages and higher unemployment leads to more negative growth and prices slide further in response to weakening demand. If consumers anticipate lower prices in the future, they are likely to postpone purchases, which further weakens demand and drives prices down. Many economists believe that a prolonged period of deflation can be far worse than inflation, because it is much more difficult to control.
How the ECB is Trying to Fight Deflation
The eurozone has been struggling with slow economic growth since 2014. During that time, inflation has nearly flamed out, dropping to near zero, with a few instances of negative inflation. Weak demand, high debt and austerity programs have steadily driven prices down. In an effort to stimulate consumer and business spending, the ECB has been lowering short-term rates. However, it has done little to boost the economy. In 2014, the ECB instituted a negative interest rate policy that only applied to banks, hoping that it would incentivize banks to keep their money working through loans and investments. Although the negative rates have yet to be passed onto retail depositors, some economists fear that it may be just a matter of time before banks are forced to pass on their cost of negative interest rates to their customers. Many European banks are already charging larger commercial accounts a negative interest rate. However, the fear of possible cash hoarding by the public reduces the likelihood that banks will pay negative interest rates on retail deposits.
The Impact on Savers
Savers in the eurozone have grown accustomed to having their money earn zero interest. In the wake of the global stock market crash of 2008 and the recent steep declines in 2015 and 2016, savers are more concerned with the return of their principal rather than the return on their principal. As long as banks remain the last bastion of safety, savers are happy knowing that their money is safe. Even if savings deposit rates do go negative, savers may consider the alternative of investing in stocks and bonds or storing their money in their mattresses too risky. At 0% interest, savers have already been earning negative returns after accounting for inflation. However, if the rate on deposits falls to far below zero, savers may find the alternative of a mattress more appealing.
The ECB hopes that, if it lowers the interest rate enough, people and business will start spending, which is what is needed to spark the economy. However, should its efforts to prevent the great deflation fail, it could have the opposite effect of discouraging spending, which could increase the prospects of a deep recession or even a depression. Critics of the ECB’s negative interest rate policy say that it is doing more harm than good, keeping companies from moving forward with investments due to the ongoing uncertainty. For savers or consumers in general, things can get a lot worse should the economy slip into a deflation-induced recession.