ECB May Repeat Japan Mistake That Triggered Lost DecadeSimon Kennedy
The central bank failed to sound a deflation alert.
“At present there is no reason to expect that overall prices will drop sharply and exert deflationary pressure on the entire economy,” policy makers wrote in their monthly report, signed off by the governor.
That governor was Yasuo Matsushita and the report was published in January 1998. Within six months, Japan’s consumer prices excluding food began falling in a trend that would mark the next 15 years.
The concern now for economists from Barclays Plc to Morgan Stanley and JPMorgan Chase & Co. is that European Central Bank President Mario Draghi risks making the same mistake as the Bank of Japan -- publicly playing down a deflation threat -- and ultimately may have to introduce quantitative easing.
Among a series of similarities between 1990s Japan and modern-day Europe: Weak economic expansion after a series of shocks? Tick. A reluctance by banks to lend? Tick. A rising exchange rate? Tick. A debatable monetary-policy stance? Tick.
“The risk of a Japanification of the euro area is high and rising,” said Joachim Fels, chief international economist at Morgan Stanley in London, who puts the odds of a price decline at about 35 percent. “Deflation wasn’t on Japan’s radar either.”
The Bank of Japan’s complacency hurt an economy that has slipped in size behind China’s as companies and consumers retrenched in anticipation of even cheaper prices. The country’s gross domestic product, unadjusted for changes in price, was 10 percent smaller last year than its 1997 peak. The Nikkei 225 Stock Average, at 14,898 today, is less than half its 1989 high, and public debt tops 200 percent of GDP.
The malaise prompted BOJ Governor Haruhiko Kuroda to pledge last year he would boost the monetary base to lift inflation to 2 percent. Consumer prices excluding food climbed 1.3 percent in January.
“Until too late, the Bank of Japan didn’t think Japan was going to be entangled with deflation,” said Kenji Yumoto, vice chairman of the Japan Research Institute Ltd. and an economic adviser to the government in the late 1990s. “The ECB still can’t be complacent. Europe is lucky to have Japan’s case study.”
A broad-based drop in prices across the 18-nation euro area would push investors into government bonds and away from the euro as the ECB began asset purchases, according to analysts at Societe Generale SA, who see a 15 percent probability of such an outcome.
While Morgan Stanley analysts say equity investors are discounting the likelihood of deflation, a relapse in growth could encourage them to buy stocks they consider resilient because of low debt or links to countries outside of Europe. These include Adidas AG, LVMH Moet Hennessy Louis Vuitton SA and Deutsche Telekom AG. Potential losers from deflation include Commerzbank AG, Air France-KLM Group and BNP Paribas SA.
Just the fact that deflation is in debate leaves Draghi under pressure as the ECB’s Governing Council prepares to meet tomorrow in Frankfurt. A month since he signaled a willingness to tackle low inflation, about a quarter of forecasters in a Bloomberg News survey say he and colleagues will reduce their benchmark interest rate from a record-low 0.25 percent. Other options are cutting the so-called deposit rate, lending cheap cash to banks and ceasing to mop up the liquidity created by crisis-era bond purchases.
“I do not think that, at the moment, the risk of materialization of the deflationary threat” is there, former ECB President Jean-Claude Trichet told reporters in Abu Dhabi today. “That being said, the low level of present inflation is something the ECB has to look at and could justify further decisions.”
Draghi maintains the euro area isn’t turning Japanese, even as he accepts that soft inflation will linger and the International Monetary Fund warns his economy may be prone to deflation if it’s hit by a shock. Medium-term inflation expectations among economists and in the financial markets remain “firmly anchored” around the ECB’s goal of just below 2 percent, and the region is strengthening, he told reporters Feb. 6 in Frankfurt.
Price pressures in the wake of Europe’s debt turmoil are similar to those following past periods of economic stress and not much worse than in the U.S., Draghi said. The weaknesses that do exist are less pervasive than in 1990s Japan and are mainly in nations, such as Greece, that must rein in prices and wages to restore competitiveness, he added.
Since he spoke, data have shown inflation exceeding forecasts, climbing 0.8 percent in February. Economic confidence also rose unexpectedly, and a report today showed an acceleration in services growth.
“We don’t see much of a similarity with what happened in Japan,” Draghi said. “There’s certainly going to be a subdued inflation -- a low inflation -- for an extended, protracted period of time, but no deflation.”
Erik Nielsen, chief global economist at UniCredit SpA in London, shares that view. He says there’s “a very low” chance the euro zone “goes into a deflation that becomes nasty.” Falling prices for energy and other goods may even help the economy by lifting spending power, he added.
“Behind closed doors” ECB officials nevertheless may be more worried than they appear in public and are concerned that voicing those worries would mean deflation becomes “self-fulfilling,” said James Ashley, chief European economist at RBC Capital Markets in London.
Barclays and JPMorgan Chase economists are less sanguine than Draghi as they review the region’s recent performance. Euro-area inflation is still less than half the ECB’s goal, and the central bankers themselves estimate it will average just 1.1 percent this year. Among the goods in the basket used to estimate the data, 23.6 percent dropped in price in January from a year ago, according to Jefferies International Ltd.
While economic growth in the euro area expanded faster than forecast in the final quarter of last year, the pace accelerated just 0.3 percent from the previous three months, and the IMF predicts expansion this year of no more than 1 percent, about a third the clip in the U.S.
Unemployment is hovering close to a record at 12 percent and tops 25 percent in Greece and Spain, while unit labor costs in the crisis-hit countries are falling. Governments still are cutting budgets to pare debt, albeit at a slower rate this year, and the euro’s 3 percent rise on a trade-weighted basis in the past year applies another squeeze.
Bank lending to companies and households has shrunk for more than 18 months, and financial fragmentation across the region means the ECB’s easy monetary policy isn’t trickling down to all. Stress tests the central bank will conduct this year may encourage a further hunkering down.
Such an environment has sent a Barclays’ indicator of euro-area deflation to the highest since the fourth quarter of 2009, when the world was emerging from recession.
In a Feb. 4 report, Barclays strategists listed parallels with Japan to probe some of Draghi’s reasons for confidence his region will dodge deflation. In one example, they noted the Japanese economy of the mid-1990s showed signs of recovering from the bursting of a real-estate bubble as it expanded 1.6 percent in 1997, like Europe’s escape from its recent recession and debt woes.
Inflation expectations also can be misplaced. A 2012 study by the Bank of Japan found it took until 2003 for economists to predict zero inflation on a long-run horizon. Barclays says while investors are signaling European inflation will be under control in five years, the options market now prices in a 20 percent chance of below-zero inflation in the next 12 months, compared with less than 10 percent six months ago. In some ways, Europe is worse off than Japan because it lacks a single financial market and has been axing budgets.
“The early-stage drivers of Japan’s deflationary shock are nearly all present in the euro zone today, although in most cases the impact is likely to be less severe” Barclays said in the report. “The risks of euro-zone deflation are higher than market pricing or policy-maker rhetoric currently imply.”
Japan’s lessons for the ECB are that an economy can suffer deflation without officials realizing it is imminent, and they should manage the risk by adopting easier policy than may appear appropriate, said David Mackie, head of western European economic research at JPMorgan Chase in London.
As in 1990s Japan, euro-region monetary policy is already too tight in his view. A Bloomberg version of the Taylor Rule suggests it has been too constrictive since the middle of 2012, just as it was for most of the past decade in Japan. The Taylor Rule uses inflation and growth estimates to measure where a central bank should set its main interest rate.
While the ECB cut its benchmark to a record low in November, it hasn’t issued three-year loans to banks since 2012, has resisted quantitative easing and its balance sheet has shrunk almost 30 percent since a June 2012 high of 3.1 trillion euros ($4.26 trillion).
By contrast, the Federal Reserve has held its key rate near zero since 2008 and a third round of asset purchases has swelled its balance sheet beyond a record $4 trillion.
“The obvious message from Japan is you have to be aware of the risks and lean against them more,” said Mackie, who added the ECB should be buying as much as 1 trillion euros of bonds.
To continue reading this article you must be a Bloomberg Professional Service Subscriber.
If you believe that you may have received this message in error please let us know.