Fall in OECD inflation highlights advanced economy monetary policy dilemmas

Year-on-year inflation in advanced economies fell for the second consecutive month in September, according to the Organisation for Economic Cooperation and Development (OECD), increasing pressure on major central banks to do more to fend off the threat of deflation.

The figures, which saw inflation in the rich country club fall to its lowest level since Japan emerged from deflation this summer, come on the heels of yesterday's forecast by the European Commission for below-target inflation in the eurozone for at least two more years.

The feeble outlook has led to mounting pressure on the European Central Bank's (ECB) executive committee to slash its benchmark interest rate by a quarter of a percentage point to 0.25% when it gathers in Frankfurt on Thursday.

Andre Sapir of the Bruegel think tank described the chances of monetary action at tomorrow's ECB meeting as "high". Markets are expecting a rate cut, he said, but added there are "other possible options", and cautioned that "all options have some difficulty attached to them."

"There's no easy way to act now," Sapir warned, and questioned the benefits of marginally lowering a rate that, at 0.5%, is already at a record low. "The whole question here is about expectations," he added, arguing that comments by ECB governor Mario Draghi during the subsequent press conference would have "as much impact on the expectations on markets as the [monetary] decision itself".

Societe Generale, which is predicting a 25 basis points cut in December, said in a note that a rate cut would weigh on the common currency and help anchor inflation expectations "that otherwise could drop sharply". It added, however, that it was doubtful whether a rate cut alone would have a "lasting effect on the euro exchange rate and a LTRO would probably have a bigger effect."

Echoing that view, Sapir said a "big bang" could only realistically be achieved through quantitative easing, or large-scale purchases of assets in the open market – "a big change of strategy that I think very few people are expecting". While warning that QE carried with it other dangers, such as artificially inflated asset prices, he argued it would be "wise to take decisions to push up the inflation rate".

Sapir also said the ECB "cannot do much" about excessively low wages in Germany, which are causing insufficient German demand, and low inflation. "The current account surplus in Germany tells me that internal demand is too weak and one part of that internal demand is linked to too low wages," he said

Europe, US and Japan converging

In the US, the tepid inflation rate may raise questions over the Federal Reserve's tapering of its own QE programme – already postponed once in September – especially in the light of fiscal uncertainty prompted by the US government's decision to delay negotiations over the federal budget and the Obama administration's ability to borrow money to offset the deficit.

Tim Hartzell, of Sequent Asset Management in Houston, Texas, argued the "disinflation theme" is a long-term structural trend "likely to play out for several years" due to demographic changes. Together with the success of QE in "offsetting some of the deflationary pressures" prompted by the financial crisis, that means incoming Fed chair Janet Yellen "may be very pressured to continue" with these expansionary policies, which could result in Fed asset purchases remaining in place for "a very, very long time".

Japan, meanwhile, which has been mired in deflation for more than a decade and earlier this year launched a campaign to push prices upwards by aggressively expanding the country's monetary base, is the only advanced country experiencing a positive trend over the past months. The Japanese inflation rate turned positive in June and is now 1.1% – the same as that of the eurozone and only 10 basis points below that of the US.