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European deflation or low inflation?

Inflation has surprised to the downside in 2014, with Euro area HICP currently running at 0.60%. While many forecasters did not expect such a surprise, we do not expect meaningful deflation

Winter 2014 / 2015

16 December 2014

Inflation has surprised to the downside in 2014, with Euro area HICP currently running at 0.60%. While many forecasters got this wrong, we do not expect meaningful deflation.(1) Brief periods of deflation are a normal part of a business cycle and usually turn out to be just brief periods of falling prices. Longer, drawn out periods of deflation are extremely rare. With the exception of Japan, all instances of past deflation were in countries with fixed exchange rate regimes. Even if there is moderate deflation in Europe, this is not necessarily bad. It can give consumers increased purchasing power, improve company production efficiency due to lower input costs, and increase exports and current account sustainability. Prolonged and pronounced deflation is another story but we do not see that happening.

According to recent research by Goldman Sachs, episodes of deflation are extremely rare.(2) With the exception of Japan, all instances of past deflation were in countries with fixed exchange rate regimes. We believe parallels with Japan are not justified for a number of reasons: (1) The ECB acted quickly to the Euro area sovereign debt crisis, whereas BoJ took several years to cut policy rates by the same magnitude; (2) there have been greater efforts to clean up and re-capitalize banks in Europe (e.g., the Asset Quality Review) than there were in Japan; and (3) it took years for Japan's residential and financial asset price bubble to deflate. The Nikkei P/E ratio was more than 50x several years after the crisis. There is little/no evidence of a price bubble or excess supply for the Euro area as a whole.

The IMF has done significant work on deflation. They looked at Protracted Large Output Gaps (“PLOGs”) and found that inflation gets squeezed toward zero but rarely to zero.

Inflation is very sticky at the 0% level because (1) employers are reluctant to cut wages in nominal terms and (2) inflationary expectations are well-anchored above zero. That said, even very low inflation can have negative consequences. Although it benefits certain segments (e.g., net savers/lenders, pension funds with defined benefit schemes, and companies with high input costs and weak pricing power), it can hinder economic recovery when there is widespread indebtedness as there is in the Periphery.(4) It can also lead wage and price setting behaviour to a lower norm and drag down longer-term inflationary expectations which could imply slippage away from the anchor provided by the ECB’s 2% objective. The recent willingness of the ECB to expand its balance sheet to early 2012 levels (an increase of €1tn) should help ease deflationary concerns and keep Euro area GDP between +0.50-1.0% for 2014.

Euro area headline inflation dropped from nearly 3% in 2011 to +0.4% annualized in August 2014. The majority of this has been the headline rate and about 70% of the headline rate decline has been in energy and food, where energy was -2.0% in August. In 2012 energy contributed to 67% of headline inflation and its contribution now is negative. Food’s contribution has fallen from 15% to almost zero.(5) 

According to the IMF, only three countries in the Euro area had outright price declines at year-end 2013, whereas in 2009 12 countries had price declines. Even then, headline inflation only temporarily dipped below 0%.

Why inflation will stabilize

A large part of reason food and energy have dropped so much in the last 2.5 years is due to the rally in the trade-weighted euro of 15%. The euro has fallen nearly 4%, however, since March 2014 and Goldman expects it to fall a further 1-2% in the next 12 months. This will dampen import deflation.

In addition, less fiscal austerity, further easing in financial conditions, an expected pick up in corporate investment, and supportive global growth later this year (especially from the US) all suggest inflation will stay positive or only temporarily dip below 0% and then start to gradually increase close to the 1% level in 2015-16. Further, any short term deflation should be moderate and limited to Spain and Portugal where there were some real estate excesses prior to the financial crisis of 2007-08.

(1) The consensus 2014 Euro area HICP forecast was +1.3% in November 2013.
(2) Goldman Sachs Global Macro Research: European Economics Daily, June 2014.
(3) IMF Working Paper: "Still Minding the Gap," August 2010.
(4) The European Periphery at the time of this writing is considered to be Greece, Portugal, Spain, Italy and Ireland.
(5) Energy and food represented 33% of total imported goods for the Euro area in 2012.

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