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Eurozone: deflationary risk is bending, but not breaking

This topic will be discussed during the Amundi World Investment Forum

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The essential

In light of the ECB’s action and the economic recovery, the risk of seeing a self-perpetuating deflationary spiral take hold in the eurozone is lower today than it was a year ago. However, disinflationary factors have not disappeared.

Beyond the effects associated with oil, core inflation will remain very low this year, leaving the eurozone highly vulnerable in the event of another adverse shock. This situation at least guarantees an accommodating bias in terms of monetary policy (potentially a significant increase in this bias if the current recovery stalls prematurely). The consequences of this low inflation on growth have turned out to be more complex than originally thought, as the sector and geographic differences are a source of problems and specific risks.

 

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The risk of seeing a self-perpetuating deflationary spiral take hold in the eurozone is clearly lower today than it was a year ago, thanks to the cumulative effects of intervention (and communication) by the ECB and an economic recovery that was a little stronger than what was expected at the end of 2014. Even with the new decline in oil prices that began in November 2015, and as the weight of energy products in the basket for calculating the HICP (Harmonised Index of Consumer Prices) for the eurozone is going to be reduced in early 2016 (from 10.6% in 2015), inflation measured by this index will gradually recover after having been in the red during much of 2015. Headline inflation should thus narrow the gap with core inflation (excluding energy and food), which today is just below1% year-on-year.

However, this improvement will do little to eliminate the many other deflationary (or, at least, disinflationary) factors likely to hamper the present economic recovery (via their effect on real rates) and to maintain high vulnerability to a genuine risk of deflation should a negative growth shock occur. Under a scenario of continued Euro area economic recovery at a moderate pace (which is today largely consensual), the most likely outcome is that inflation will remain low for longer, yet possibly with significant divergences across sectors (likely to have a complex effect on growth) and countries (with the possibility that it could be an additional factor of tensions among Member States). This perspective has major implications, first in terms of common monetary policy and second as regards the necessary microeconomic treatment (structural reforms) and vigilance concerning new political risks.

 

Today’s climate is of enduring low inflation rather than deflation

In early 2015, core inflation set an all-time low of 0.6% in year-on-year terms since the creation of the single currency. The spillover of lower oil prices certainly played a role (core inflation is not immune to oil prices since nearly all goods and services include an energy component in their production cost structure, which, if it falls, is always likely to be passed on in the selling price). But disinflationary pressures did not wait for the price of oil to fall: as a reminder, since the Great Recession of 2009-2010, core inflation has never been above 1.5% per year for any meaningful period of time and headline inflation indexes were already in slightly negative territory in a few peripheral countries (Spain and Portugal, not to mention the dire case of Greece) in early 2014 (graph 3).

Core inflation has since slightly recovered but continues to be short of breath (+0.9% in December 2015, or a 0.7 pp contribution to headline inflation, graph 1), in virtual stagnation since the summer and unable to break decisively above 1%.

However, at least two strong signals suggest that the eurozone has been distancing itself, at least temporarily, from a self-perpetuating deflationary spiral.

  • The sectoral components of inflation are almost all positive: remember that one of the generally recognised warning signs of the threat of deflation (criterion mentioned many times by the ECB) is the spread of price cuts to multiple sectors. Looking at their trends stepping back a year or two (applying a 3-year moving average as a filter), none of the 10 components of the first level of core inflation has been falling (graph 4) except for communications, a sector with high technological content extremely prone to virtuous productivity (and competition) deflation and that has been structurally in negative territory since well before the 2009-2010 crisis.
  • The GDP deflator is increasing and shows an additional margin of safety relative to the message sent by the Core HCPI. The deflator is a wider indicator that includes capital goods (equipment and property), adds export prices but leaves import prices out. Although imprecise and subject to frequent revision, it currently points to a domestic economic climate that is a little more inflationary than what is suggested by consumer prices alone (+1.3% yoy in Q3 2015 after hitting a low of 0.8% in Q2 2014, graph 5). We note in this respect that the return to a slightly positive trajectory of house purchase prices after the violent “bubble” bursts in recent years has likely eliminated one of the deflation factors that are economically (and psychologically) the most determining, although not directly measured in the HICP. More specifically, we note that the eurozone GDP investment component deflator, after hitting a low of +0.2% in Q2 2013, is slowly recovering (+0.6% in Q3 2015).

 

Little to no acceleration in inflation in sight, in particular for services

However, despite this improvement, the economic climate in the eurozone is not very conducive to pick-up in inflation.

- First, unlike its very swift impact on the energy component of prices (a lag of at most two months, as shown in Graph 2), lower oil prices will influence the various core inflation components in a far more disparate and even enduring manner and are probably going to leave their negative mark on 2016.

- Moreover, the main economic variables that are usually regarded as determining as far as domestic inflationary pressures are concerned will be unlikely to trigger acceleration any time soon (here we restrict ourselves to their impact on services inflation as goods inflation also has a strong component linked to the exchange rate):

  • Long term inflation expectations (such as measured by market instruments) are well below 2%. However, while closely watched, their predictive power is questioned by the fact that their short term moves have been largely influenced by actual headline inflation (and thus oil prices) in recent months.
  • The output gap (graph 6), whatever the differences in its measurement between major international institutions, is largely negative (-2% according to the OECD) and should, despite a slight recovery, remain so throughout 2016 and 2017.
  • The persistently degraded state of the labour market (graph 7) does not suggest, at least for 2016, a decline in the unemployment rate below a threshold that would trigger upward pressure on inflation (NAIRU, estimated at 9.4% by the OECD compared to an unemployment rate of 10.5% in October 2015 and which has eased only 1 percentage points in a year). Moreover, the US experience suggest that there is a lot of potential for the NAIRU to be revised at a lower level in the current economic cycle.
  • There is no detectable sign of a pick-up in unit labour costs (graph 6), as wage gains are very modest while productivity continues to improve (albeit slowly).
  • Lastly, some of the reforms advocated by European institutions (and implemented primarily by countries having benefited from international assistance programmes) are aimed at lowering prices (or limiting their rise) in particular sectors where margins are deemed excessive and/or competition is seen as very much lacking. In this sense, some of the deflationary pressure in the eurozone is desired and perceived as virtuous, as was the price of oil (and likely, just as oil, to cause a reflation effect in other sectors). However, we note that these reforms were often combined with austerity measures that integrated, conversely, increases in regulated prices designed to alleviate the public debt burden. These impacted goods and services in sectors that were often not the most competitive (for instance, we recall that in Spain between December 2011 and December 2012, in the midst of a recession, the health component of the inflation index rose by more than 13%!).

 

The depreciation of the euro will lead to a slight uptick in goods ex-energy price inflation

As it is very unlikely to be driven by services, core inflation should, on the other hand, receive a fillip from a slightly stronger goods inflation dynamic, excluding energy and food (which is looking up after having been extremely low or even negative in 2014 and during most of 2015). This is mainly due to the exchange rate effect via import prices (whereas the persistence of overcapacity is going to continue to limit domestic inflationary pressures. See graph 8).

While the pass-through from the lower euro to import prices was fairly fast, its effect on the bulk of industrial prices, except for energy, was considerably deferred and amortised but still visible during past fluctuations (See graph 9). Accordingly, assuming a stable exchange rate in 2016 (which is in line with our central scenario), some of the 2014-2015 downward effect of the euro’s effective exchange rate is still to make a positive contribution to inflation, along the lines of 0.2 to 0.3 percentage points this year. Such an outlook is consistent with the orders of magnitude of a model such as the one used (Global Model) by the OECD, which projects a 10% fall in the euro’s effective exchange rate (roughly corresponding to the movement observed between the median 2014 level and that of 2015), translates into a pick-up in inflation along the lines of 0.3 percentage points each year for three years).

Overall, under our baseline growth scenario (GDP growth of approximately 1.5% in 2016, with no additional pick-up in 2017), inflation is set to increase but in a very limited manner. Our forecasts of 0.9% in 2016 and 1.5% in 2017 are now at levels comparable (although still slightly lower) with the GDP growth rates that were recently revised downwards by the ECB (1% in 2016 and 1.6% in 2017).

This scenario has a number of implications in terms of growth and the appropriate policy mix:

  • The first implication relates to monetary policy. Eurozone inflation will not recover the margin of safety necessary any time soon to prevent a deflationary spiral from becoming a major risk in the event of an unexpected negative shock on growth. Whilst any sort of policy stance normalisation by the ECB is still on the distant horizon (there is no guarantee that the ECB will phase out its asset purchase programme in February 2017), the assumption that inflation again below the central bank’s forecast (and even more so in case of another growth hiccup) would necessitate the use of more ambitious unconventional tools cannot be ruled out. The first stage would likely take the form of an extension, in terms of time or volume, of the measures already put in place, including the broadening of the scope of asset purchases to other markets, but, beyond that, the necessity of bridging the gap between monetary policy and fiscal policy (monetary financing of a stimulus programme) could emerge in the next few years.
  • The second implication relates to the manner in which very low inflation has an impact on economic activity itself. A potential major negative channel is real rates that, increased by the weakness of inflation, can hamper investment, a situation that is only corrected imperfectly and with major delays by monetary policy. It should however be noted that the problem of which inflation indicator to use to compute real rates (general index, core, measures of inflation expectations, or just value added prices that could be the only relevant ones for companies) cannot be easily solved. Above all, the observation of recent developments in the most crisis-hit Eurozone countries shows that this process is anything but mechanical. Core inflation or services inflation essentially behaved like lagged variables, reaching their lowest point only after the low point of the recession. The case of Spain is particularly striking: the entry into negative territory of most inflation indexes in late 2013 or early 2014 did nothing to prevent a far stronger recovery than what was expected to occur during the same period. Without denying that the real rate effect might have been present and exerting a negative influence, very low inflation also very probably helped household consumption recover (well before the plunge in the price of oil amplified this trend).
  • Beyond the overall level of inflation, differences across sectors will continue to be major concerns. The danger of excessively low inflation is not necessarily a reason to ignore the particularly undesirable character of a few pockets of high sectoral inflation where they relate to uncompetitive sectors, captive buyers and/or inelastic demand. Such rises are, by nature, likely to generate ultimately deflationary crowding out effects on other sectors (for instance, among the positive contributions to core inflation shown in Graph 4, the contribution of the “hotels and restaurants” industry, which is fairly competitive, may be better news than the “housing” item, integrating services markets where multiple administrative or geographic barriers to the exit of consumers and the entry of suppliers)* prevail. This problem of so-called “excessive margins” tends to deprive monetary policy efforts from long lasting benefits if they are not accompanied by vigorous efforts at microeconomic reforms (focused not only on the labour market but also and perhaps most importantly on the goods and services markets including the (central or local) government institutions that are major players in pricing mechanisms across many sectors).
  • Lastly, on top of these wide sector differences, the eurozone aggregate also includes substantial differences between Member States. Some of the disinflationary factors listed above (negative output gap, high unemployment rate, contained unit labour costs, deflationary reforms) that constrain inflation prospects are far less pronounced in Germany (and in other Northern European countries) than in the greater part of the remaining eurozone. Despite other disinflationary factors specific to Germany, which will come into play in 2016 and 2017 (oversupply on the jobs market as some of the refugees who arrived in 2015 join the labour force, lack of any formula to reassess the minimum wage, which drove the cost of labour higher in 2015), a scenario pitting a substantial rise in inflation in Northern countries against stagnation elsewhere cannot be ruled out. Likely to amplify political wrangling on the Governing Council of the ECB and even increase Euroscepticism among the population segments most hostile to inflation, this would add new life to this old challenge of the common monetary policy, only adding to the many issues questioning the cohesion of the monetary union.

Prices are continuing to rise slightly in most major sectors

2016-01-04-01

The GDP deflator shows inflation which is slightly higher than the core HICP index

Unit Labour Costs, the output gap and unemployment are not currently conducive to an acceleration

2016-01-04-02

Negative inflation has not prevented a strong recovery in Spain

2016-01-04-03

 

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Cross Asset of January 2016 in English

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Tristan PERRIER, CFA, Strategy and Economic Research at Amundi
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Eurozone: deflationary risk is bending, but not breaking
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