Euro area deflation is unlikely to be long-lasting
In April and May, consumption prices in Latvia were slightly lower (by 0.5%) than a year ago. Moreover, consumer price inflation in the euro area overall is slowing down considerably and approaching zero.
A short-lived decline in consumer prices or deflation is nothing unusual: it has been observed several times both in Latvia and the euro area as a whole (most recently, in 2015 and 2016). Deflation can cause serious economic problems when the long-term inflation expectations fall below zero. If the general public believes that prices will persistently fall for several consecutive years, it can lead to a deflationary spiral, with consumers postponing their purchases and businesses laying off employees and decreasing wages, thus creating additional downward pressure on demand for goods and services, etc. Currently, this scenario is unlikely.
First, the fall in consumer prices is limited to certain sectors, and there is no indication that it will last. In March and April, the global market saw a sharp decline in the price of oil which lead to unusually low fuel prices (less than one euro per litre). Against this background, the heating tariffs and natural gas prices are also likely to decline in the coming months.
Meanwhile, the services prices are not expected to record a sharp fall. Under the current conditions, restaurants and hairdressing salons are unlikely to compete with lower prices both due to the distancing and disinfection measures driving up business costs and also because of several state support programmes, e.g. furlough benefits and tax holidays, allowing businesses to temporarily suspend their operation without loosing their commercial space and employees.
At the same time, prices of several food products, e.g. buckwheat, cottage cheese and apples, continue rising. Consumers do not foresee deflation either: in May 2020, a much larger share of people surveyed in Latvia and the euro area overall expected prices to increase steeper rather than decrease. Moreover, oil prices have already bottomed out: Saudi Arabia and Russia, the world's largest oil exporters, have finally come to an agreement on oil output curbs. In addition, the demand for oil has increased as a result of gradual lifting of the measures taken to contain the spread of Covid-19. Over a month, the price of oil has doubled to 40 US dollars per barrel, and Latvian drivers have already seen some increase in the fuel prices.
Second, the European Central Bank (ECB) is keeping its finger on the economy's pulse to prevent a prolonged economic downturn which could lead to persistently low consumer prices and push the inflation expectations into negative territory. The ECB aims to keep inflation "below, but close to, 2% in the medium term", and is consistently signalling its commitment to employ all monetary policy instruments at its disposal to reach the above inflation target within the scope of its mandate.
The ECB is currently implementing several measures to support the euro area economic recovery. For instance, in response to the Covid-19 pandemic, the ECB launched a new asset purchase programme at the end of March. The envelope for the temporary pandemic emergency purchase programme was initially set to 750 billion euro, and on 4 June 2020 it was increased by 600 billion euro to a total of 1.35 trillion euro.
In order to overcome the Covid-19 crisis, the ECB policy has enabled the euro area governments, inter alia the Latvian government, to borrow funds in the financial market at a cheaper rate. Thus, the Latvian government is actively borrowing funds in the international financial market at a very low interest rate (close to zero) and is using these funds to support households and the overall economy. This means lower unemployment growth and a less pronounced decrease in income for businesses and individuals. Perhaps most importantly, it gives them a sense of belonging and safety. Finally, it should be noted that it is the euro area membership that has enabled the Latvian government to support the economy by means of additional expenditure, instead of tightening the belt as was the case in the crisis of 2009.