MacroScope

Japan-style deflation in Europe getting harder to dismiss

February 13, 2014

To most people, the idea of falling prices sounds like a good thing. But it poses serious economic and financial risks – just ask the Japanese, who only now finally have the upper hand in a 20-year battle to drag their economy out of deflation.

That front is shifting westward, to the euro zone.

Deflation tempts consumers to postpone spending and businesses to delay investment because they expect prices to be lower in the future. This slows growth and puts upward pressure on unemployment. It also increases the real debt burden of debtors, from consumers to companies to governments.

In many ways, policymakers fear deflation more than inflation as it’s a more difficult spiral to exit. After all, interest rates can only go as low as zero and if that doesn’t kickstart spending, they’re in trouble. Again, just ask the Japanese.

European leaders and financial markets insist the threat of deflation in the euro zone is low. Outside experts surveyed by the European Central Bank said this week they saw a “very low” probability of deflation. And this is what European Central Bank president Mario Draghi said last week:

“We have to dispense once more with the question: Is there deflation? and the answer is ‘No’.”

But Draghi and others  should guard against complacency.

Inflation across the 18-nation bloc is falling fast, last at just 0.7 %. That’s well below the European Central Bank’s target of “below, but close to” 2%, it’s the lowest in the developed world, and down from 3% barely two years ago.  According to analysts at Barclays:

“The risks of a region-wide deflationary period are significant, and certainly bigger than what is currently priced into financial markets or being publicly acknowledged by eurozone policymakers. Either way, the likelihood of a prolonged period of falling price levels in at least several eurozone countries looks very likely.  The early-stage drivers of Japan’s deflationary shock are nearly all present in the eurozone today.”

They draw comparisons with Japan’s experience and find several parallels:

• Asset price deflation in the euro zone has been more modest in the aggregate, although house/land price falls in some peripheral countries are comparable to Japan’s episode

• The real effective euro exchange rate has not been as big a driver of the deflation trend, but it is an increasing drag on prices

• Tight fiscal policy has pushed the euro zone output gap to levels more negative than they were in Japan at a similar stage of the crisis

• Uneven monetary policy (too tight in periphery, too loose in Germany), along with ongoing internal devaluations have pushed several countries into deflation already

• Global disinflation pressures remain relatively large, thanks at least in part to weak commodity prices, China’s overcapacity and a weak yen

Among the charts they use to illustrate their argument are these two, which show the deflationary impact of contracting bank loans:

 

 

Overall, this is how Barclays measures the risk of deflation in the euro zone. High and rising:

 

 

Even those who see minimal risk of outright deflation, like economists at JP Morgan, are cautious:

“We are not predicting a slide into deflation in the Euro area, but given the Japanese experience no one should be surprised if it happens. We are especially concerned about the reluctance of the ECB to set the policy stance consistent with the prevailing macro landscape, let alone one that leans against downside risks.”

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