It is far too early to discount the threat of deflation, notably in Europe where the policy response may have been less strong, or less effective, or both.
Data released in Germany recently showed that producer prices fell by 4.6 percent in the year to June. The fall was considerably steeper than economists were expecting, and was the fastest fall in 40 years.
The German Finance Ministry was quick to reassure, saying that the chances of a deflationary spiral had diminished, maintaining that price signals were mixed and that the labor market remained ‘remarkably robust’.
The adjusted jobless rate, for those of you keeping score at home, now stands at 8.3 percent in Germany, but is rising and can reasonably be expected to keep on rising even if the much touted green shoots turn into an immaculate recovery.
There is more than a little to fear from deflation in a number of places around the world, from Japan to Canada, though some of the figures flashing red are partly the result of the very sharp fall in energy prices compared to a year ago.
Consumer prices are falling at the fastest rate on record in Japan, are negative in Canada, and in Britain are now below the Bank of England’s target two percent rate of increase.
Consumer prices across the euro zone fell in June by one percent from a year earlier, the first such fall in the 13 years data has been compiled.
This should not be a surprise, despite extraordinary measures to fan inflation, ranging from slashing interest rates to buying up debt. Debt busts are deflationary and there are billions of individuals and companies around the world pulling hard in the opposite direction from officaldom, by paying down debt, by building up cash, and by putting off investment.
“Growth has plummeted and unemployment has risen in developed and developing countries alike. Significant excess capacity has built up, and unless this issue is addressed, we will face a deflationary downward spiral and the crisis will become protracted,” World Bank chief economist Justin Lin said in a speech in South Africa.
Given the data it is remarkable, to say the least, that the word deflation doesn’t even merit a mention in the European Central Bank’s July monthly report, all 200 plus pages of it.
Indeed, ECB chief Jean-Claude Trichet has been careful to say that the deflationary threat has yet to materialise in Europe. If you are going to be worried about deflation in Germany and elsewhere in Europe that’s a pretty good reason.
Output gap and deflation
And while the ECB is engaging in its own version of quantatative easing, flooding its banking system with one year funding at the low, low rate of one percent, there is less control over how the benefit of that is allocated between healing the banking system and actually reflating the, for want of a better term, real economy. So, let’s look at Germany for a moment.
Gabriel Stein, at Lombard Street Research in London, thinks the German output gap, the difference between output and capacity, will widen rapdily from an already chunky 7.5 percent of gross domestic product in the first quarter. This will pressure inflation, and given the squeeze on profits at German companies, a round of inflationary wage increases is unlikely.
“A bout of temporary deflation, even in consumer prices looks more likely than not,” according to Stein. Everything in life is temporary, I suppose, but deflation is one of those forces that can be tenacious once it takes hold. And Germany is positively thriving compared to say, Spain, where wages will need to be greatly compressed to bring back competitiveness. And yet the discussion is not about when the ECB cuts rates but how long it takes until they are again raising them.
Barclays Capital has a very useful measure where it looks at the past interest rate policy of the ECB and its predecessors and compares it to market and economic data to show how the bank would have reacted had its reactions to current conditions remained consistent to its track record.
On that basis, the ECB’s interest rate ought to be, not the current one percent, but minus one percent. Well, that’s not going to happen, and neither it seems will a massive programme of buying up debt.
The easy call is that government debt in the eurozone might do quite well, with room to rally from even current low interest rates.
The other easy one is that the ECB will be, compared to their British, US and even Swiss peers, slow and cautious to react to continued signs of deflation and stress as they occur.