Will the debt crisis increase European inflation?

As long as the European Central Bank (ECB) sells other assets, its purchase of government bonds won't cause inflation.

Andrea Comas / Reuters / File
Countries that have increased consumption taxes may see a short-term raise in price inflation, and those that have focused on spending cuts may experience deflation.

There is worry in Germany that ECB purchases of government bonds will cause inflation.

But that will only be the case if the ECB breaks its pledge to "sterilize" the bond purchases by selling other assets. To the extent the purchases are sterilized by sales of other assets, it will have no effect at all on either money supply growth or price inflation.

Similarly, the loans that other euro area governments gives to Greece and Ireland (and in the future possibly Portugal and Spain) are not inflationary since they are financed by the sale of bonds. The "purchase of bonds" from Greece and Ireland are thus in effect "sterilized" by equal size sales of bonds from the other governments.

The effect of fiscal austerity on inflation that the debt crisis have made governments implement depends on whether or not a country has increased consumption taxes or not. For countries that have increased consumption taxes, the short-term effect will be to raise price inflation, something we have seen in particularly Greece, Portugal and Spain. For Germany and other euro area countries, particularly those that have focused on spending cuts in their austerity program, the effect will be deflationary for reasons that I explained here.

Thus, assuming that ECB really keeps its pledge to "sterilize" bond purchases and do not let the crisis affect its interest rate policy, the effect of the response to the crisis will in fact be the opposite of what is assumed in Germany.

However, that is arguably two questionable assumptions. Despite some hawkish comments from Jean-Claude Trichet earlier this week. it is highly unlikely that the ECB will really raise interest rates as long as the crisis is not perceived to be over. For the same reasons, the ECB might not sterilize its purchases fully.

That means that ECB rate hikes could come later than they otherwise would have and that its balance sheet could increase, something which would counteract the deflationary effects of spending cuts, and perhaps even mean that the net effect will be to increase inflation.

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