Inflation used to be the main focus for European central bankers’ interest rate policy as prices rose forever upward. Now their main fear as we begin 2014 is the reverse scenario – the risk of deflation. It is potentially a huge problem, as falling prices mean that consumers do not buy goods because they expect them to become cheaper in the future, stalling economic growth and triggering a recession. However, there are three reasons why a Japanese-style era of falling prices that cost the country a ‘lost decade’ in the 1990s will not take hold in the Eurozone, says Robeco’s Chief Economist, Léon Cornelissen.
“The economic recovery, a strong will by policymakers and a wholly different culture combine to make deflation extremely unlikely in the Eurozone,” says Cornelissen in his January outlook for investors.
It’s thanks to the euro’s success!
The risk has ironically been largely caused by the recent success of the euro. After years of underperformance as the Eurozone lurched from one crisis to another, the euro has appreciated by almost 13% against other major currencies since mid-2012. The Japanese experience was that a strong yen markedly contributed to the country’s slide into deflation in the 1990s.
The evidence for deflation is certainly getting stronger. Figures published on 7 January showed that headline inflation fell to 0.8% on an annualized basis in December 2013 from 0.9% in November. Core inflation – which strips out more volatile food and energy prices – fell to a record low of 0.7% in December. But this implies disinflation, where the rate at which prices rise is reducing, rather than the more dangerous deflation, where prices actually fall.
“We see three arguments for optimism that deflation will not take hold in the euro area,” says Cornelissen. “Firstly, the Eurozone is experiencing a recovery, and the southern periphery in particular is enjoying an upswing. So it is hard to see how an accelerating European economy can fall into a deflationary trap.”
“Of course, some argue that the European recovery isn’t self-sustaining, and due to ongoing austerity measures, a fall back into a recession is likely. Not so. It is more likely that budget deficit and debt targets will be postponed once again until Eurozone economies are fully back on track.”
Super Mario will act on instinct
Then there is the political and regulatory will. “Mario Draghi, the president of the European Central Bank (ECB), has already said that he is well aware of the deflationary risks and is prepared to act against them,” Cornelissen says. Inflation is already well below the ECB’s 2% target, but Draghi has insisted it cannot be allowed to permanently fall below 1% “and thus into ‘the danger zone’.”
“As interest rates in the Eurozone head towards zero, this is a clear signal that the ECB is prepared to resort to unconventional monetary measures if the need arises, putting pressure on the euro exchange rate and limiting deflationary risks.”
Thirdly, there are also significant cultural differences between Europeans and the Japanese, Cornelissen says. “The prospect of a Japanese-style deflationary environment is politically unacceptable within the Eurozone,” he says. “The long stagnation period in Japan can be partly explained by the unusually consensus-driven and mono-ethnic nature of Japanese society, which was prepared to suffer for the national good. Such stoicism is unlikely within the Eurozone.”
Banking union is the real problem
Cornelissen says the real potential threat to deflation getting a foothold is “the slow, insufficient, unsatisfying progress towards a true banking union within the Eurozone, which is a recipe for slow growth.”
“Such a scenario fails to break the link between weak banks and weak states, and reminds observers of the Japanese-style ‘convoy system’ which keeps afloat the zombie banks that keep alive zombie companies, preventing creative destruction and a reset. That is, of course, partly true for the Eurozone.”
“However, the general health of the European banking sector is better than that of the Japanese. As such, the unhealthy tolerance of weak banks and sovereigns within the Eurozone is in our opinion more of a long-term problem for the bloc. This issue will be obscured by the ongoing recovery and therefore is insufficient to push the zone into Japanese-style deflation.”
It is also important to remember that the Eurozone has been in this situation before in the period just after the 2008 financial meltdown, Cornelissen says.
The Eurozone survived a brief period of deflation in 2008/09
As the graph above shows, in 2008/2009 a dramatic drop in inflation ended in a five-month period of mild deflation. “Such a short-term period of mild deflation is not a disaster, so long as deflationary expectations do not become entrenched. We are still far from such a development in the Eurozone,” Cornelissen says.
Robeco’s forecast is for inflation to gradually rise to 1.2% in the Eurozone in 2014 as growth picks up, in line with the consensus of other investment managers.