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THE INVESTOR
ANALYSIS
DEFLATION
Getty Images
Near zero inflation in
Spain is not helping
to resolve the severe
unemployment
problem there
Balance sheet
There is a fear now of the shadow
of deflation spreading across Europe.A real threat to
consumer demand and employment would mean the
ECB having to take action.
THE INFLATIONARY CURE?
One of the factors contributing to deflation in the
eurozone has been the appreciation of the euro.While
the economic recovery on the continent is lagging well
behind that of the US and the UK, investors have been
enthusiastic about its recovery prospects and less
concerned about the threat of a break-up of the euro,
helping push government bond yields down from the
high rates reached during the depths of the crisis
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That, coupled with the downward pressure on
the dollar from the huge quantitative easing (QE)
programme in the US, means that the euro is well
above its 2012 lows against the US currency
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As the US continues to taper QE, however, the euro
may start to weaken, particularly if the ECB decides to
embark on its own QE programme – and president
Mario Draghi has made it clear that the programme
announced at the start of the summer will not be the
last.That could help to ease the deflationary pressures.
Weaker commodity prices have also been a factor in
pushing inflation down, not just in Europe but in the
US, China and the UK, which have all been experiencing
falling prices.That is due partly to the global economic
slowdown, which is reducing demand for the basic
materials which go into the manufacturing of consumer
durables. But, as the economics team at EY points out:
‘As the world economy recovers, so will commodity
prices. Combined with a modest improvement in
business confidence and pricing power from 2015
onwards, these developments should boost inflation
from 0.7% in 2014 to 1.2% in 2015 and 1.6% over
the medium term.’
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Mario Draghi, president of the ECB, has
consistently rejected suggestions that the
eurozone will slip into de ation. In June
he told a press conference
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:‘We don’t see
de ation.We don’t see that typical feature of
a self-ful lling negative spiral of self-ful lling
expectations.We don’t see households
postponing their spending plans and we don’t
see the various features of this phenomenon
that I have mentioned on other occasions.’
His comments came as the ECB announced
a package of measures aimed at stimulating
the economy, and staving o further price
falls, including introducing a negative interest
rate, of -0.1%, on its deposit facility which
e ectively means that banks that deposit more
than the capital required under solvency rules
with the ECB have to pay for the privilege.
The aim is to encourage them to lend
more, and so stimulate the economy.The ECB
is also considering stimulating the economy
further by creating asset-backed securities,
which it will then buy back itself.
‘The longer it [the period of low in ation]
lasts, the higher the risks.And that’s what
we are reacting to.We are reacting to a risk
of a too-prolonged period of low in ation,’
said Draghi.
The size of the debt burden in countries
like Greece, Italy and Portugal means that
a bout of in ation would be very welcome.
Capital Economics’ Loynes uses the example
of Italy where, assuming real GDP growth of
about 1% a year and an average in ation rate
of 1.5%, government debt will peak at 130%
of GDP before falling to 90% of GDP by
2030. If in ation simply falls to zero, however,
the debt burden will remain stuck at around
the current level.
‘If in ation were negative, the damage
could be much greater,’ wrote Loynes.‘Such
a debt pro le would force Italy and other
countries facing similar prospects either to
impose punishing amounts of additional scal
austerity or, perhaps more likely, to follow
Greece in undertaking some form of default.’
One of the lessons of history might be
that decisive action is needed to stave o
the de ationary threat. Japan is accused of
failing to act quickly and radically enough to
prevent two lost decades; the UK and the
US both undertook extensive quantitative
easing programmes of market support
and, while in ation in both places has been
falling in recent months, they are not facing
the prospect of de ation.
The IMF’s Moghadam said:‘One needs
to act forcefully before de ation sets in.
The Bank of Japan was relatively slow in
lowering policy rates and ratcheting up base
money. In the event, it had to resort to ever-
increasing stimulus once de ation set in.
Two decades on, that e ort is still ongoing.’
While the ECB may have cut interest
rates more aggressively than the Japanese,
and the central bank’s action on rates and
asset purchases over the summer was more
radical than expected, it still did not amount
to the‘bazooka’ that some observers have
wanted. If eurozone in ation continues to
fall, the clamour for more radical action
will intensify.
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