Line graph of annual price change (%) showing the euro area is facing a third deflation

Lagarde's deflation dilemma: the virus increases stimulus pressure on the ECB

The day after Christine Lagarde unveiled the European Central Bank's latest monetary policy decision on Thursday, new figures are expected to show the euro area has fallen for its third straight month of deflation – something it has only done twice before.

Fears that Europe is stuck in a cycle of Japanese growth with weak growth, negative interest rates and below zero inflation is likely to dominate discussions among ECB policymakers this week, even if they are unlikely to take immediate action.

Friday's dismal price data is accompanied by rare good news for the euro zone. The gross domestic product numbers are expected to show record growth of almost 10 percent between the second and third quarters – recovering from a deep recession in the first half of this year.

Those numbers already seem out of date, however, as a resurgence of coronavirus infections and tightening government restrictions – including curfews in France, Italy and Spain – threaten to push the 19-country bloc into a two-break recession.

In response to the darkening outlook, Ms. Lagarde is expected to signal clearly that further incentives can be expected in December.

Does monetary policy even work in this phase?

The challenge for the ECB President is that given the euro area slipping towards further downturn and governments still arguing over the details of the EU's € 750 billion recovery fund, doubts about the ability of the Central bank emerge to get the economy out of the collapse.

"The problem is that the fourth quarter looks like a catastrophe," said Lucrezia Reichlin, an economics professor at the London Business School and a former research director at the ECB. "We have to avoid Japan's mistakes, and that means doing more in a more concerted manner in fiscal and monetary policy."

Although monetary policy "has a very marked effect on reducing the spread (the gap in lending rates between riskier and safer borrowers)", Ms. Reichlin warned that "there is a big question mark about how much will translate into higher inflation" .

When Ms. Lagarde was named to succeed Mario Draghi as ECB president almost exactly a year ago, many commentators believed that her Italian predecessor had used up most of the ammunition in the central bank's stimulus armory. However, since then the ECB has found several new ways to inject cheap money into the economy.

First of all, an emergency purchase program for bonds worth EUR 1.35 billion was started, which waived the self-imposed limits that threatened to restrict the purchase of assets. Second, it was agreed to accept bonds as collateral even if they were downgraded to below investment grade status after the pandemic began. And eventually it began lending banks at rates as low as minus 1 percent – the first central bank to lend below the deposit rate.

These measures – along with a massive fiscal stimulus launched by eurozone governments – have been widely credited with preventing the pandemic from sparking another debt crisis in the bloc.

However, the main objective of the ECB is to achieve price stability, which it defines as inflation close to but below 2 percent. This goal has not been achieved for years, despite buying trillions of euros in bonds and cutting interest rates deep into negative territory. Now economists are warning that it seems further away than ever before.

According to Athanasios Orphanides, the former head of the Central Bank of Cyprus, who is now an economics professor at the MIT Sloan School of Management, the ECB is in a "lowflation trap". "Since 2012 the average inflation rate has only been 1.1 percent."

The ECB found new weapons to fight the pandemic

Others, like Daniel Harenberg, an economist at Oxford Economics, believe that Ms. Lagarde is facing "secular stagnation". Anatoli Annenkov, economist at Société Générale, said: "Does monetary policy even work at this stage?"

Given the damage the pandemic resurgence is likely to do to parts of the economy, the ECB has admitted that deflation is likely to last until early next year if it hopes a reversal of German tax cuts will boost prices.

Such a long period of deflation is unhealthy for an economy because it can discourage consumers from spending and businesses from investing if they believe prices may be lower in the future, while increasing the real burden of repayment on debtors.

Recent surveys of consumers and businesses in the euro area showed that confidence and activity have fallen sharply since coronavirus infections hit new highs in many countries this month. Another worrying sign for the ECB is that banks curtailed lending in the third quarter and announced that they would tighten credit standards further in the final months of the year.

The ECB's forecast of 3.1 percent GDP growth in the fourth quarter seems increasingly unlikely, and it is widely expected that Ms. Lagarde will signal that further monetary stimulus is likely unless the outlook is fixed before her next meeting Interest rates improve in December.

However, if the central bank is to avoid getting caught in a deflationary spiral, economists say governments may need to provide even more fiscal stimulus.

"I think that by the end of the year there will be a new bazooka from both the European financial side and the currency side," said Ms. Reichlin. "You will have to keep pumping with all you have."