Europe faces deflation threat: James Saft

October 31, 2013

Oct 31 (Reuters) – Europe faces a threat of deflation, which
it seems unlikely to be willing to fight.

Core inflation in the euro zone fell sharply in October to
just 0.8 percent a year, the lowest since early 2010 and a level
which sets the red deflation light flashing.

Deflation, or even low inflation, is particularly bad news
for Europe, whose particular burden is too much debt. Inflation
eats away at the real value of debt, thus making it easier to
bear. Deflation does the opposite.

This raises pressure on the European Central Bank, which has
a monetary policy meeting next week, to do something radical,
though they have but limited options when it comes to the what
and the how.

Buried in the inflation figures was one number which shed
light on the euro zone’s plight: the prices of services fell 0.2
percent in October, and are down 1.2 percent from a year ago.
Services, of course, are what Europeans perform largely for one
another, and since the number of people needing work so far
outpaces the available opportunities, a crushing deflation in
what they can charge ensues.

And because the euro zone ties all member states to the same
exchange rate, those places like Greece and Spain with the worst
unemployment are forced to compete internationally to sell
traded goods and services with the likes of Germany, making
deflation the natural outcome.

Euro zone unemployment rose to a record high of 12.2 percent
in September, according to data released on Thursday, with an
all-time record of 24.1 percent of those under 25 years old
jobless. Unsurprisingly, French consumer spending and German
retail sales are both falling outright.

“So the question of the day can be couched into what can the
ECB do to make policy more accommodative,” Bob Savage of Track
Research wrote in a note to clients.

“Some banks are now calling for another 25 bps easing in the
refi rate. Others stick to the 9M LTRO idea. Some are thinking
of more forward guidance linked to CPI. All equal a lower euro.”

Though the euro zone common currency fell nearly 1 percent
against the dollar on Thursday, that still leaves it some
6 percent higher over a year, a burden on exporters.

NO COSTLESS OPTIONS

The idea of a new or additional LTRO – long-term loans
offered to banks to drive market interest rates lower – is baked
into most economists’ forecasts. More than 1 trillion euros of
LTRO loans were made in 2011 and 2012 and the first repayments
are due early next year.

As for reducing interest rates, it will be tricky. The main
refi rate is at 0.50 percent, but the deposit rate is already
zero. If the deposit rate went negative, implying a charge on
banks for funds held at the central bank, banks might be more
likely to make loans but would face difficulties in their own
operations. It would also cause problems in bond and other
funding markets.

Forward guidance, a fancy central banker term for making a
promise about what you will do in the future, is seen as a sort
of magic bullet for banks facing the zero bound of interest
rates. Commit to keep rates low for longer and you can influence
markets, the theory goes, to price credit more cheaply for
longer periods. In its most recent ECB Monthly Report, the bank
said again that rates will remain at the current low or lower
levels for an extended period in order to support a gradual
recovery in euro zone economic activity.

The other question, of course, is what reaction other
central banks and governments have to a falling euro. The U.S.
on Wednesday took aim at Germany for what it said was creating a
“deflationary bias” for the euro area by maintaining a large
current account surplus. In the absence of some sudden uptick in
German demand for Greek, Italian and Spanish goods, a lower euro
will only reinforce that, and might invite U.S. ire.

As well, the Federal Reserve and Bank of Japan are both
fighting their own wars against falling inflation in the U.S.
and outright deflation in Japan. While a small move in the euro
might be tolerated, a larger one would raise tensions.

The real problem, as ever in the euro zone, is that the
solution will involve German authorities tolerating inflation at
home, specifically inflation in German wages. That would drive
German consumption and narrow the competitiveness gap within the
euro zone. To put it bluntly, this is unlikely.

That leaves the euro zone dependent on global growth, which
may or may not deliver the inflation needed to make its debts
bearable.

That growth may or may not arrive, but what is certain is a
lot of suffering in peripheral Europe while we wait and see.
(At the time of publication, Reuters columnist James Saft did
not own any direct investments in securities mentioned in this
article. He may be an owner indirectly as an investor in a fund.
For previous columns by James Saft, click on )

(Editing by James Dalgleish)

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