Denying Deflation; Definitely Dangerous

From Stephen Pope, Managing Partner, Spotlight Ideas

  • Economic sentiment rose to 101.2.
  • Business Climate Index increased to 0.37.
  • Consumer expectations for CPI declined to 13.6.
  • German CPI falling; R2 with Eurozone 0.8929.
  • ECB must act on March 6th.

This penultimate day of February delivered a mixed bag of news for the Eurozone.  On the positive side the monthly European Commission (EC) survey of regional economic sentiment improved by more than was forecast in February. However, inflation expectations among consumer and producers are still tumbling and serve to reinforce the risk of deflation.

Economic sentiment in the 18 countries that now comprise the Eurozone rose to 101.2 in February from an upwardly revised 101.0 in January. This is encouraging as it is above the long-term average of 100 for the third consecutive month. The expectation on the street had been only 100.9; this is a welcome surprise to the upside, Figure 1.

There was similarly good news in that the EC Business Climate Index increased to 0.37 from an upwardly revised 0.25 in January. The February observation was in excess of estimates at 0.20 and is registered as the strongest reading since July 2011, Figure 2.

However, among the data sets released today the sentiment of consumer expectations for inflation on a 12-month forward projection declined to 13.6 for February from 15.1 a month ago and producer price inflation expectations tumbled to a miniscule 0.1 from 2.4 in January. These latest observations are considerably less than the long-term averages for price growth expectations and serve to reinforce the opinion that the sharp slowdown in Eurozone inflation (Figure 3) could eventually become so entrenched that the region enters a deflationary spiral.


Figure 1: Eurozone Economic Sentiment Index  (Source: European Commission)             

Figure 2: Eurozone Business Climate Index  (Source: European Commission)

Figure 3: Eurozone Consumer Price Inflation (CPI %)  Source: Eurostat

The level of CPI YoY was 0.8% in December and January after readings of 0.9% and 0.7% in November and October 2013 respectively. This is of course a problem for the European Central Bank (ECB), which is mandated to keep consumer price growth below, but close to 2.0% over the medium term. It will no doubt be a high priority issue of the order of business when the Governing Council  meets on monetary policy next Thursday, March 6th.

Repeatedly President Mario Draghi has said that the ECB is aware of risks and was ready to act should they increase, however, this has been tempered by the repeated utterance that neither he nor the Governing Council perceives any threat of deflation in the Eurozone now or in the foreseeable future.

At the previous ECB policy meeting on February 6th 2014 President Mario Draghi cited the need for

“…more information…”

That could explain why he hadn’t added more stimulus yet. He repeated on February 23rd 2014 that officials are

“…ready to take any action…”

At Spotlight Ideas we feel he should pay close attention to the regional inflation data that was reported in six German Lände today.

Inflation in six German regions slowed this month; this fuelled speculation the ECB would expand monetary stimulus. Annualized inflation in the Saxony region slowed to 1.2% in February from 1.4% in January. Consumer prices also rose at a slower pace in the regions of Hesse, Bavaria, Baden Wuerttemberg, North Rhine Westphalia and Brandenburg. This has to infer that the national rate is slowing; according to economists estimates Germany’s annual rate, calculated using a harmonized European Union (EU) method, eased to 1.1% this month from 1.2% in January.


Figure 4: CPI (YoY %) Germany and Eurozone (Source: Eurostat)

Figure 5: CPI Correlation (Source: Eurostat)

If we accept that the weakening trend of inflation in the German Lände is a solid indicator that national CPI will slip then the correlation between German CPI and that of the Eurozone overall makes for interesting reading. The level of R2 for the 61 observational pairs since January 2009 is 0.8929. Surely this is not a statistic that the ECB can afford to ignore. Given the exchange rate is designed to suit the German export machine one would think that the Governing Council should pay close attention to the inflationary trend, or lack of it within the region’s leading economy.

The data on regional price expectations and German price pressures should be supportive for policy easing, and the bullish tenor within the bond market whilst partly driven as a flight to safety in a risk-off run from equities and the Ukraine/Emerging Market situation can also be seen as due to expectations that the ECB could do and should do more.

The risks that develop from deflation:

However, it cannot just be German data that shapes opinion. Deflation is a period when the general price level falls i.e. the cost of a basket of goods and services is steadily becoming less expensive. It is normally associated with falling levels of aggregate demand (AD) that will lead to a negative output gap as actual GDP is less than the potential GDP. Or if a new advance is made and exploited so deflation can be caused by an increase in productive potential, which leads to an excess of aggregate supply (AS) over demand. These points can be shown in the following way.

Figure 6: AS-AD diagrams to illustrate two causes of deflation
via a fall in aggregate demand and a rise in long-run aggregate supply
Source: Spotlight Ideas

The critical reasons that could occur within the Eurozone that would lead to deflation are refraining from spending as corporations and consumers opt to postpone consumption demand if their expectation is for prices to fall further in the future.

One has to bear in mind the level of debt; the real value of debt rises when the general price level is falling and a higher real debt mountain (corporate and individual) will drain confidence and willingness / ability to spend.

Compared to the US the Eurozone has proven to be a significant under performer in reducing this private sector debt burden. Given an aggressive stance on writing off bad mortgages by lenders, a greater willingness to pay down mortgages and other loans by the private sector and a greater clip in GDP, US corporations and households have cleared approximately 60% of the excess debt accumulated  during the last years pre the crash.

In contrast many Eurozone countries have been slow to deliver private sector “deleveraging” given the fiscal austerity, weak bank stress tests and an inability to recognise, and write-off bad debt and the law surrounding bankruptcy is less debtor friendly than it is in the US. There is a less positive attitude taken toward debt re-structuring.  Corporate bankruptcy procedures are extremely slow and expensive to administer.

The corporate debt problem is worst in Portugal, Spain and Italy, where the IMF says that 50%, 40% and 30% of debt, respectively, is owed by firms which cannot cover their interest payments out of gross earnings meaning these firms are unable to invest or grow.

In the US the proportion of income that the average household spends on servicing debt is the lowest in decades cf. Spain it is higher than during the boom years. According to the IMF, private debt is a bigger drag on Europe’s growth than government debt and we all know how much has been said about that.

This can lead to an issue for taking on new debt with which to invest as the drift toward deflation sees an increase in the real cost of borrowing. Without investment corporations will endure lower profit margins that will lead to panic discounting and so a fall again in CPI.

If the Eurozone does dive into deflation is it benign or malign?

If falling prices are caused by higher productivity, it can go hand in hand with economic growth. However, if deflation reflects a slump in demand and persistent excess capacity, it can be dangerous. If the falling price level is simply the result of improving technology or better managerial practices that is acceptable as activity will ultimately catch up.

In stark contrast malign deflation occurs when prices fall because of a structural lack of demand which creates excess capacity in an economic system. With Eurozone unemployment stuck at 12% this is clearly a worry. If AD slumps companies will go out of business and be forced to make redundancies and hence demand falls again. With many nations already heavily in debt looking to a government stimulus is unrealistic. Therefore the negative multiplier starts to have its effect.

Olli Rehn the EU’s Commissioner for Economic and Monetary Affairs said earlier this week that low inflation across the whole Eurozone would make price reductions in the peripheral economies less effective at generating a lift to competitiveness.

“…Prolonged low inflation could not be an excuse for not reforming, but it would make the rebalancing undoubtedly harder,…”

So not only will the periphery be neutered when it comes to the terms of trade given the exchange rate is out of their control, they will also be unable to effect a meaningful internal devaluation. That would in turn create further difficulties in geographically rebalancing the EU economy.

His comments were made as the EC reduced its Eurozone inflation forecast after soft CPI readings at the end of last year and the start of 2014. Growth may be improving, however, the pace of GDP growth is still glacial and the second and third largest regional economies are struggling under a lack of reform and either weak (France) or untested (Italy) leadership.

The ECB will announce its next policy decision on March 6th, we hope that President Draghi does not dither but acts with at least 15bps of the refinancing rate, introduces a negative deposit rate and pushed for unsterilsed asset acquisitions.


Contact Stephen Pope at Spotlight Ideas

on +44 (0) 7931 543740 or +44 (0) 1255 863612

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