Low Bond Yields in Europe Could Signal Deflation
News flash: Spain is now able to borrow almost as cheaply as the U.S. Yes, Spain, a nation with 26 percent unemployment, red ink in the national budget, and an economy that has shrunk in 17 of the last 23 quarters, has five-year government bond yields of just over 1.7 percent. Italy’s borrowing cost is only un po’ più elevato. Even Portugal has a government bond yield merely a percentage point higher than that of the U.S.
Now for the asterisk, because things are never simple in Europe. It’s unquestionably good that the peripheral nations of Europe have stepped back from the brink of default, emboldening investors to accept lower yields on their government bonds. The problem is that the very austerity measures that lessened the risk of default may have contributed to a new danger in Europe: deflation. To use a metaphor from Greece, whose government borrowing costs have also plunged, Europe managed to steer clear of the rocks of Scylla only to head for the whirlpool of Charybdis.
Past a certain point, falling interest rates go from being helpful to a little scary. An extremely low interest rate can signal that investors have no faith in a country’s ability to grow on its own and that they expect central banks to keep official rates superlow for a long time to gin up economic activity. One thing that continues to depress European economies is fiscal policy: the combination of spending cuts and tax increases that helped governments prove they were serious about balancing budgets and winning back investors’ confidence.
The debate over whether Europe’s austerity was too harsh may never be settled, but it’s clear that the euro zone as a whole hasn’t been able to climb out of its rut. Its inflation rate slowed to 0.5 percent in March, the lowest level in more than four years. That’s well below the European Central Bank’s inflation goal of just below 2 percent. In Japan, cycles of economywide price declines known as deflation have been endemic since 1990. When prices fall, debt burdens become heavier, and companies and consumers are afraid to borrow. Low interest rates on government bonds don’t help. “The euro zone faces a creeping danger: the risk that allowing inflation to run so far below the ECB’s own definition of price stability for so long will eventually topple the monetary union into outright deflation,” wrote Janet Henry, chief European economist of HSBC, in a note to clients on April 7.
In France, five-year government borrowing costs are 0.9 percent, which is well into dangerous territory. French President François Hollande is trying to get permission from the European Union to slow the country’s deficit-reduction effort, which he believes is partly responsible for France’s economic weakness. The country hasn’t had growth of 1 percent or better since 2011. He dispatched two ministers to seek the support of their German counterparts on April 7.
Interest rates fall when the demand for funding is weak because of a big “output gap,” the slack between what the economy is capable of producing and what it’s actually putting out, says Angel Ubide, a senior fellow at the Peterson Institute for International Economics in Washington. Believers in austerity argue that stabilizing government finances will give businesses the confidence to expand, shrinking that output gap, but it’s a painful process, says Mauro Guillén, director of the Lauder Institute at the University of Pennsylvania in Philadelphia. Speaking mainly of Spain, he says: “Of course the austerity measures will eventually work, but it’s going to take them a long time.”
Speculation is a big factor in the latest decline in bond yields in Spain, Italy, Portugal, and Greece. Bond prices rose another notch—and yields fell—after ECB President Mario Draghi said on April 3 that the central bank was considering unconventional, i.e., more extreme, measures to stimulate growth and stave off deflation. He said the bank’s Governing Council was “unanimous” on exploring tools including purchases of debt, a European echo of the Federal Reserve’s quantitative easing (QE) program.
But quantitative easing wouldn’t be as easy for Draghi to carry out as it has been for the Fed. The ECB’s founding treaty prohibits it from financing governments, which is essentially what a central bank does when it buys government bonds. Even if it got around that rule, the ECB would have to make politically fraught decisions about which countries’ bonds to buy. To avoid that issue, it might instead buy private debt securities such as mortgage-backed bonds. “If you think the ECB is about to launch a meaningful QE operation, you’ll be disappointed,” wrote Erik Nielsen, UniCredit’s chief global economist, in a client note on April 6.
If the ECB succeeded in its mission to stimulate the European economy, interest rates would go up, not down. Stronger growth would increase the demand for loans, and inflation would pick up, both of which would raise the rates lenders and bond buyers demand to let go of their money. So when interest rates fall, it’s a sign that investors expect the ECB to do a lot more to get growth going—and, at least initially, to fail. That, in a nutshell, is why the news flash out of Madrid is not entirely good news.