Right now, Europe looks like it's stuck in the same trap that Japan has been for decades. Now, there's a common misconception that this can't be so, because low, positive inflation is okay, and it's low, negative inflation (deflation) that would be truly damaging. But that's not true. There's no bright, red line at zero inflation. Lowflation and deflation are, as the IMF points out, just a continuum of the same problem. In both cases, real debt burdens are higher than they otherwise would be, and relative cost adjustments—say, between one country's wages and another's—are harder.
But maybe this is just a blip? Maybe Europe isn't actually turning Japanese? After all, core inflation predicts future inflation better than the headline number, so it should start rising towards 0.8 percent, right? Well, maybe not. As the Financial Times points out, markets don't expect euro inflation to rise at all in the next five years -- at least not according to breakeven rates. These rates subtract inflation-protected bond yields from unprotected ones to give us an idea of expected inflation. I only say "give us an idea," though, because inflation-protected bonds are so thinly traded that their yields aren't always reliable.
Still, as you can see below, German and Italian five-year breakevens have collapsed to 0.5 percent the past few months, just like inflation has.
That leaves us with a puzzle: why have breakevens fallen more than core inflation? Well, it could be that there really isn't any mystery here. That, for idiosyncratic reasons, these breakevens are overstating the decline in inflation expectations, and other measures show them staying stable—at least that's what ECB chief Mario Draghi said in his press conference on Thursday.
But there's a less sanguine possibility: maybe markets don't think the ECB will allow, or be able to create, rising inflation. That might seem unlikely since the ECB just introduced new measures in June to fight its falling inflation. But the ECB still resisted doing what it really needs to—quantitative easing—because buying sovereign bonds is a political mine field in Europe.
So it's possible that markets think the ECB has done enough to stabilize, but not increase inflation, and won't do any more. That'd certainly fit its character. Indeed, for all Draghi's done getting the ECB to be more aggressive, it's still a central bank that cares about low inflation über alles. As you might remember, the ECB actually raised rates twice in 2011 to snuff out inflation that had blipped higher than 2 percent due to temporarily higher oil prices. All that did was snuff out Europe's recovery.
Europe's inflation is already too low, and it's going to stay that way for too long—even if everything goes according to plan. It needs a better plan. It needs to do more.