Does low Eurozone inflation indicate a lack of demand?

According to the Eurostat’s flash estimate, Eurozone inflation dropped to 0.3 percent in August (relative to August last year). This is the lowest rate of inflation since 2009, and it’s far below the ECB’s target rate of 2 percent. The financial press was quick to conclude that it’s about time for Mr. Draghi to “do more”. Since the ECB’s tool set of conventional policy is exhausted (key interest rates are essentially zero), this can only mean quantitative easing or some other unconventional policy. Now, it’s far from clear that such policies are at all effective and it’s even less clear that they are feasible given the ECB’s internal politics.

But I want to leave those questions aside for the moment and ask a more basic question: does the low inflation rate really indicate a lack of aggregate demand, or are there some supply side forces at work? The significance of this question should be obvious: if it’s a supply side shock, there’s not much the ECB can do about it, and perhaps it shouldn’t do anything about it (the answer to the latter is no, if you think Eurozone’s AD curve is downward sloping, and yes if you think it’s upward sloping  due to debt-deflation effects).

So here’s the key chart from Eurostat’s press release:


As you can see, the low headline inflation rate is entirely driven by energy and food. Prices of services on the other hand, have risen (although also below the 2 percent target). What do we learn from that? Well, energy and food are tradable goods whereas services are mostly non-tradable. So the data show an increase in the relative price of non-tradables. The prices of tradables are determined in the world market, while non-tradable prices are determined domestically. If low headline inflation was due to depressed domestic demand, we should see prices of non-tradables fall relative to tradables. Yet we see the opposite.

It definitely seems that lack of aggregate demand is not the main driving force behind the Eurozone’s low inflation. Instead it’s falling energy and food prices. Admittedly, even if we exclude energy and food, inflation is still well below target (about 1 percent in August). So I’m not claiming AD has nothing to do with low inflation. I’m just saying it’s not the main culprit.