Draghi Europe Scenario Points to Lowflation Still PainfulSimon Kennedy
For all the fears of a Japan-style era of deflation, a more likely threat for Europe is what International Monetary Fund officials are calling lowflation.
A sustained period of ultra-low, albeit rising, inflation still has the potential to destroy output, hurt hiring and revive memories of the recent fiscal crisis by hammering the ability of governments to repay debts. With data yesterday showing inflation about a quarter of the European Central Bank’s goal of just below 2 percent, President Mario Draghi is under pressure to respond.
“It is imperative to return inflation to the target as quickly as possible,” said David Mackie, chief Western European economist at JPMorgan Chase & Co. in London. “The ECB needs to acknowledge having low inflation for a long time isn’t neutral.”
Draghi and fellow policy makers convene in Frankfurt on April 3 with gains in the consumer-price index having faded to 0.5 percent in March, the weakest in more than four years. That reinforced speculation Europe is increasingly at risk of deflation.
Those fears may be misplaced, as suggested in recent speeches by Draghi and illustrated in a March 4 IMF blog. Prices fell in four countries -- Greece, Cyprus, Portugal and Slovakia -- in February compared with 12 in 2009. Four-fifths of the components in the region’s consumer-price index are rising, and energy-price declines explain a lot of the broader slowing.
In a sign the economy is firming, purchasing-manager indexes released last week showed factory and services activity in the first quarter was the strongest in almost three years, and confidence in the region was the highest since 2011. Meanwhile, the so-called five-year, five-year forward break-even rate, a gauge of inflation expectations in the five years starting 2019, remains around 2 percent.
For now, Draghi is forecasting a strengthening economic recovery will eventually lift inflation, which the ECB sees averaging 1.3 percent next year and 1.5 percent in 2016 after 1 percent this year.
“If any downside risks to this scenario appear, we stand ready to take additional monetary-policy measures that ensure our mandate is fulfilled,” Draghi said in Paris on March 25. “In other words, we will do what is needed to maintain price stability.”
Among his options: another interest-rate cut after lowering the main refinancing rate to a record low 0.25 percent in November, charging banks to park funds at the ECB overnight, lending them fresh cash or ceasing to absorb liquidity from crisis-era bond buying. He even could begin quantitative easing, which Bundesbank President Jens Weidmann said last week is permissible in certain circumstances.
Skirting deflation is certainly no reason to declare victory, given “ultra-low inflation can also be very problematic,” said Reza Moghadam, director of the IMF’s European Department in a video accompanying its blog. The Washington-based lender warned weak inflation could suppress growth and push debt, unemployment and borrowing costs higher.
Royal Ahold NV already feels the impact. On Feb. 27, the Dutch owner of Stop & Shop and Giant grocery stores blamed low inflation in part for “broadly flat” sales in the fourth quarter, when operational income fell 7.5 percent at constant exchange rates to 320 million euros ($441 million).
Standard Life Investments, which oversees 184.1 billion pounds ($307 billion), has noted the inflation outlook in advising investors to be “heavy” in European bonds, said strategist Frances Hudson in Edinburgh. The two-year inflation swap rate in the euro region dropped to 0.88 percent on March 31, the least on a closing basis since February 2009 and a sign financial markets are betting on disinflation in the near-term.
Officials also cite recent gains in the euro as a growing source of weak inflation that threatens to hurt exporters and reduce import prices. Economists polled last month by Bloomberg News identified $1.43 per euro as the ECB’s “upper acceptable limit.” The currency was at $1.38 yesterday.
Most at risk from lowflation are the so-called peripheral economies, such as Greece and Portugal, which slashed wages and budgets following bailouts. These countries, as well as Ireland and Italy, are grappling with debt above 100 percent of gross domestic product and inflation below 1 percent.
Governments typically can rely on accelerating prices to ease debt loads, according to Laurence Boone, chief European economist at Bank of America Merrill Lynch in London. Boone calculates that even if inflation remains subdued, debt burdens as a share of GDP will increase in the next six years by 24 percentage points for Spain, 21 points for Italy and 10 points for France, raising the risk of fresh fiscal austerity.
“Debt dynamics could be seriously damaged by continuing surprises” on price gains, Boone said.
Regional banks that still have nonperforming loans and large debts face the same dilemma, said Stephen King, chief global economist at HSBC Holdings Plc. Continuing weak inflation may dissuade them from lending more to businesses and households.
Setting a common interest rate for multiple nations punishes those with the lowest inflation by inflicting tighter monetary policy than if they had their own central bank, said Antonio Garcia Pascual, chief euro-area economist at Barclays Plc in London. The pain is even greater because rates can’t be cut much lower.
Given the ECB’s 0.25 percent benchmark, Greece faces a tighter inflation-adjusted, or real, rate of 1.15 percent after its consumer-price index dropped 0.9 percent in February. By contrast, Germany’s 0.9 percent price increase in March gives it a relatively looser real rate of minus 0.65 percent. Draghi said last week the central bank’s vow to keep borrowing costs low means short-term real rates should become more supportive of growth as inflation picks up.
Sluggish inflation also hampers efforts to reduce unemployment, which at 11.9 percent for the euro area in February was just shy of a record 12 percent. Typically businesses can respond to weaker demand by refusing to increase wages, which lowers the inflation-adjusted cost of labor. When there’s no price acceleration, they can’t do this, so they have to eliminate jobs to save money.
“A moderate inflation helps with nominal wage rigidity, allowing real wages to decline and so softening the impact on employment,” said the IMF’s Moghadam. “This possibility disappears when inflation is low or negative.”
JPMorgan’s Mackie says lowflation is exacerbated by the fact that inflation expectations are “firmly anchored” around the ECB’s goal. If they declined, the ECB would have more room to let the economy overheat without worrying about inflation accelerating too fast in the medium-term, making up for output lost during the slump.
Assuming the euro-area is operating now at 6 percent of GDP below its long-term trend, Mackie’s calculations suggest there could be an annual output loss of 572 billion euros if the economy isn’t allowed time to make up for the present weakness.
The lingering danger is the longer inflation remains weak, the more prone the region is to deflation, which would be harder to reverse -- as Japan has shown, said Anatoli Annenkov, an economist at Societe Generale SA in London.
“If you see a shock, that’s a big issue,” he said. “There is a risk we easily fall down into a deflationary scenario.”