The pace of the slowdown in economic activity is alarming and is raising the prospect of strong disinflation rapidly turning into deflation. Expectations of average inflation over the next 10 years, derived from inflation indexed bonds, have already collapsed and are now close to zero (see Graph).
The ECB needs to win the race against disinflation. To prevent inflation from falling to zero and deflation to take hold, interest rates need to be slashed. Failure to do so will trigger a Japanese-style scenario of soaring real interest rates, higher debt burdens, postponed spending and a continuously depressed economy.
With inflation expected to fall to around 1% in 2009 and nominal GDP expected to stagnate, the euro area needs to bring interest rates down to 1% or even lower.
The ECB can make a good start to do so by cutting interest rates tomorrow by at least 100 base points.
Says Reiner Hoffmann, ETUC Deputy General Secretary: ‘With the economy in the grips of a strong process of disinflation, the argument of keeping central bank munition dry is dangerous. If saved for later and if deflation sets in, interest rate cuts will be mostly ineffective. The time to shoot is right now .’