Eurozone deflation – still a threat, but not inevitable

Recent data has underlined the ongoing slowdown in price growth in Eurozone countries, and the slip into at least temporary deflation in some of the most heavily indebted economies, writes Tom Rogers.

Looking at the Eurozone as a whole, prices grew by just 0.3% in the year to August, down from 0.4% the previous month and 1.6% in the year to July 2013. Part of the slowdown can of course be explained by the strength of the Euro in 2013 and the first half of 2014, as well as the easing of commodity prices over the same period. But domestically generated inflation has weakened a touch over the past year too; in light of the tentative recovery from the Eurozone crisis and high rates of unemployment, businesses and workers are both facing an unprecedented squeeze on their pricing power. In a recent speech at Jackson Hole, Mario Draghi highlighted that these pressures were now not only feeding their way into contemporary price pressures, but starting to erode longer term expectations of the rate of price growth.

As such, the risk of a prolonged period of prices, wages and costs growing at rates slower than their long-run trend would appear to be increasing. This matters immensely for the highly-indebted households, firms and governments that took on debt expecting the income they would use to service it to grow by 2 percent or so per year. A period of falling prices and costs (or indeed even weak growth) would mean that the burden of debt relative to income would increase, forcing debtors to decrease their consumer spending, business investment and hiring, or public spending respectively. In turn, this could push Europe into a damaging cycle of falling output, falling wages, increased debt burdens, and eventually debt defaults and restructuring.

Underpinning inflation expectations at rates consistent with their long run averages is therefore critical to ensuring that the Eurozone survives in its current formation. Fortunately, we think there are reasons to expect inflation to start to slowly rebound in the coming months – partly driven by external factors and partly due to the response of the European Central Bank.

Firstly, monetary policy cycles are now patently diverging in the US, UK and Eurozone. Discussions across the Atlantic and the English Channel are increasingly focussing on when, not if, interest rates will rise. But with huge amounts of spare capacity in most Eurozone economies, interest rates are unlikely to rise until the final years of this decade. The Euro is responding to this, depreciating by 5% since April against the dollar. This is less than many in the region would like perhaps, but certainly a step in the right direction, and we expect further falls in the months to come. This will both increase the cost of imported goods, but more importantly improve the competitive position of exporting firms around the region, and their employees’ willingness to spend.

Additionally, the global recovery is starting to underpin energy and food prices. Based on our analysis of what has already happened in commodity markets (which feed through to shop prices with a fair lag), we expect energy and food prices to boost the overall growth rate of consumer prices by around 0.3% in the coming months, rather than push inflation lower, as has been the case over most of the past two years.

For its own part, the ECB has unveiled a range of policy measures to try to boost the rate of recovery in the Eurozone. For now it has stopped short of large scale asset purchases (often known as “Quantitative Easing”), and we expect this to continue to be the case as long as inflation expectations remain broadly consistent with its mandate to keep inflation “close to but below” 2 percent. But the long-term lending operations announced in June, combined with the conclusion of the Asset Quality Review, will hopefully provide banks with an opportunity to resume lending. Alongside ongoing efforts to reform and improve competitiveness, this could spur a recovery in business lending from next year onwards, boosting activity and firms’ pricing power. Overall, therefore, while we expect inflation in 2014 to be well below the ECB’s 2% target (at just 0.7%), the direction of travel should be increasingly upwards – to 1.2% in 2015 and 1.5% the year after.

Nevertheless, the ECB will need to remain vigilant in the near term to further deflationary pressures. With business and household confidence still fragile in many economies it would not even take a substantial shock to tip the Eurozone from tentative recovery back into recession, and with it push inflation well below zero. This would increase the likelihood of self-perpetuating cycle of deflation and deleveraging taking hold. In this circumstance the ECB would need to stand ready to implement a more aggressive (and, experience from Japan tells us, rapid) response – directly injecting money into the Eurozone economy via asset purchases, rather than making it available to banks to lend to firms that have no interest in taking on further debt.